DOJ Brings First Criminal Charges for Trades Under a Rule 10b5‐1 Plan

On March 1, 2023, the Department of Justice (DOJ) announced the insider-trading indictment of Terren Peizer, Chairman and former CEO of health-care provider Ontrak. DOJ called this indictment “groundbreaking,”^[1] in that it is the first-ever criminal prosecution based entirely on stock sales made pursuant to a Rule 10b5-1 plan.^[2] The same day, the Securities and Exchange Commission (SEC) filed parallel civil fraud charges against Peizer. These developments reflect a recent focus on Rule 10b5-1 plans by the SEC.

Use of these plans helps create an affirmative defense to insider trading by insiders who schedule in advance their securities transactions and do not influence trading decisions thereafter. But the Peizer matter is the latest in a series of signals that Rule 10b5-1 plans will be scrutinized by the SEC’s continued and enhanced use of data analytics to flag suspicious trading patterns and will not necessarily be an effective shield from enforcement actions. This Client Alert reviews key recent developments, then identifies some actions companies and executives should consider to minimize their exposure for trades made under these plans.

Background

First adopted in 2000, Rule 10b5-1 provides protections to insiders who adopt a plan when they do not possess material nonpublic information (MNPI) and other conditions apply. A valid plan provides an affirmative defense to insider trading charges.

For years, however, many critics have argued that the rule enables insiders to use these plans to exploit inside information. Critics have pointed out, for example, that the rule has permitted insiders to adopt a plan one day and trade the next—possibly exploiting MNPI an insider possessed when adopting the plan. It also has enabled insiders to have multiple plans in effect at the same time. Critics say this allowed insiders to exploit MNPI by, for example, cancelling previously scheduled sales if they acquired inside knowledge that earnings would exceed or not meet previously disclosed expectations.

The SEC has brought earlier cases that included alleged misuse of 10b5-1 plans. In 2009, the SEC charged Angelo Mozilo, CEO of Countrywide Financial, with insider trading that included the alleged misuse of 10b5-1 plans. This included adopting separate plans in three consecutive months in the fall of 2006, allegedly with inside knowledge of growing weakness in the company’s loan portfolio. Mozilo settled and agreed to pay disgorgement of $45 million and a penalty of $22.5 million, at the time a record penalty for an individual.^[3]    

September 2022: The SEC brings civil fraud charges for trades made under Rule 10b5-1 plans

Against this background, DOJ and the SEC recently have been conducting reviews of trades made pursuant to Rule 10b5-1 plans. These reviews involve the SEC’s continued and enhanced widespread market surveillance tools that apply computer algorithms to flag questionable trades, especially those in close proximity to disclosures or announcements by companies. Based on the leads obtained through this surveillance, the DOJ and SEC have been serving subpoenas on companies and individuals.

In September 2022, these investigations led to an SEC enforcement order based entirely on trades made under a Rule 10b5-1 plan, In the Matter of Sheng Fu and Ming Xu. According to the order, two executives of application developer Cheetah Mobile, Inc. were aware that their company was experiencing a substantial decline in revenue from a major customer. With the benefit of this MNPI they created a new joint Rule 10b5-1 plan, and promptly began selling their shares. The company subsequently disclosed the revenue decline, and its share price fell 18%. By selling before this earnings announcement, the two executives had avoided losses totaling about $300,000.

The SEC’s order found that the executives had engaged in fraudulent conduct in violation of Section 10(b) of the Securities Exchange Act of 1934, as amended, and Rule 10b-5 thereunder, prohibiting fraudulent conduct in connection with the purchase or sale of securities. The order imposed penalties totaling more than $750,000—more than double the losses the executives had avoided. Significantly, the order also required undertakings that included a cooling-off period for certain future plans, a prohibition on overlapping plans, and certain future certifications of compliance with the undertakings. These undertakings reflected the SEC’s aggressive approach to this matter: The undertakings imposed requirements not found in the then-current version of Rule 10b5-1, but the SEC would codify similar requirements several months later when it amended the rule as discussed further below.

March 2023: The first criminal insider-trading charges involving a Rule 10b5-1 plan

The DOJ did not file criminal charges in the Cheetah Mobile matter. But several months later it brought the first prosecution for trading under 10b5-1 plans, obtaining the Peizer indictment. According to the indictment, Peizer learned MNPI that indicated a “serious danger” that the company’s largest customer would terminate its contract with Ontrak. Peizer then established a new Rule 10b5-1 plan and, the next day, began selling shares. About three months later, Peizer learned that the customer’s termination of this major contract had become “likely.” That same day, Peizer established another new Rule 10b5-1 plan and, the day after that, began selling shares. About five days later, the customer terminated its contract. Ontrak promptly disclosed this news in a current report on Form 8-K, and its stock price fell by 44%. According to the indictment, Peizer had sold stock worth approximately $20.7 million before the company disclosed the MNPI, thus avoiding losses of more than $12 million. The indictment charges Peizer with one count of engaging in a securities fraud scheme and two counts of insider trading. He faces a maximum of 25 years in prison on the first count and 20 years on each of the insider trading counts.

The same day the DOJ unsealed the indictment, the SEC filed a parallel civil complaint, charging Peizer with violating antifraud provisions of the securities laws. The complaint seeks disgorgement of “all ill-gotten gains;” civil penalties in an amount to be determined; and an officer and director bar.

The Recent Amendments Tightening Requirement for Rule 10b5-1 Plans

Since January 2022, the SEC has been publicly engaging in rulemaking to tighten the requirements for Rule 10b5-1 plans. The rulemaking process ended in December 2022, when the SEC adopted several changes that took effect on February 27, 2023. For a detailed description of the amendments, see Orrick’s Client Insight, What You Need to Know About the SEC’s Amendments to Enhance Investor Protections Concerning Insider Trading. In particular, the amended rule imposes for directors and executive officers a "cooling-off period" of at least 90 days after plan adoption, during which trades are not permitted.^[4] This change prevents directors and executive officers from adopting a plan then trading immediately, as Peizer and the Cheetah Mobile executives did.^[5] The amendments also generally prohibit the use of multiple, overlapping plans, limiting the available affirmative defense to one single-trade plan in any 12-month period. Additionally, the amendments require that individuals act in good faith with respect to their plans.^[6]

Managing Enforcement Risk

It is the rule amendment took effect and the Peizer cases were brought within days of each other. These developments—in enforcement and rulemaking—suggest several considerations for companies and individuals involved with Rule 10b5-1 plans. Companies should, of course, review their policies and internal controls in light of the new amendments. See Orrick’s client insight, What You Need to Know About the SEC’s Amendments to Enhance Investor Protections Concerning Insider Trading. Companies should assume that their internal controls could themselves be the target of government scrutiny.

In connection with this review and subsequent monitoring, companies should be aware that the lower-risk plans tend to follow a regular pattern for each individual—for example, by addressing the same period each year and reflecting a discernible long-term strategy. Plans that depart from a regular pattern might present higher risk and warrant a closer compliance review.

Companies also should consider that, though the requirement for cooling-off periods reduces the probability that a trade was based on MNPI, in the eye of a regulator it does not eliminate that possibility. Even when a trade complies strictly with this requirement—a trade made the day after a cooling-off period ends, for example—it still might draw scrutiny under the government’s enhanced market surveillance program. Companies and executives should plan accordingly.

Another area of uncertainty is the scope and nature of information the government might consider to be MNPI, in particular the question of when certain information is “material” and “nonpublic.” The definition of MNPI can be less than clear, despite the abundant body of relevant case law, and investigators are likely to take an expansive view. Adding to the uncertainty, regulators will evaluate materiality with the benefit (or distortion) of hindsight.

When assessing enforcement risk, companies and individuals should not assume trading in relatively smaller dollar amounts is risk-free. Market surveillance methods might identify trades as suspicious based primarily on timing or additional factors other than the amount of the benefit to the trader. The SEC in particular might pursue a perceived violation regardless of the dollar amount.

Finally, although the new amendments to Rule 10b5-1 do not apply to existing plans, companies and individuals should review those plans to mitigate potential risk in light of the current enforcement environment.