Undoing a Deal with the Devil: Some Challenges for Congress's Proposed Reform of Insider Trading Plans

Recent studies have suggested that insiders are availing themselves of Securities Exchange Commission (SEC) Rule 10b5-1(c) trading plans (Trading Plans) to beat the market by trading their own company’s shares based on material nonpublic information. For years, the SEC has been aware of industry concerns over the strategic use of these Plans by insiders, but it has hesitated to act. Congress is, however, poised to force the agency’s hand. In January 2019, Financial Services Committee Chair Representative Maxine Waters (D-CA) introduced a new bill, the Promoting Transparent Standards for Corporate Insiders Act (Corporate Insiders Act). If passed, the Corporate Insiders Act would require the SEC to study a number of proposed amendments to 10b5-1(c), report to Congress, and to then implement the results of that study through rulemaking. The bill was co-sponsored by Representative Patrick McHenry (R-NC) and is therefore likely to receive bipartisan support. But there is a problem. The SEC adopted Rule 10b5-1(b) in 2000 to define trading “on the basis of” material nonpublic information broadly as trading with mere “awareness” of such information. The rule makers anticipated concern from the courts that imposing liability on a person who is merely aware of material nonpublic information while trading (without a causal relation between the information and the trade) may not satisfy the requirement of scienter under the general anti-fraud provisions of Section 10(b) of the Securities Exchange Act (and might therefore exceed the SEC’s statutory authority for regulating insider trading). There was also the concern that the broad awareness test may chill legitimate trading by insiders (e.g., for portfolio diversification), which would negatively impact the value of firm shares as a form of executive compensation. To address these concerns, the rule makers added Rule 10b5-1(c) Trading Plans as an affirmative defense to insider trading liability. To qualify, a Rule 10b5-1(c) Trading Plan must (1) be writing; (2) detail the amount, price, and date of the securities to be purchased or sold, or include a “written formula or algorithm” that determines the Plan transactions; (3) it must have been entered into while the insider was unaware of material nonpublic information; (4) the insider must not have any subsequent influence “over how, when, or whether to effect [particular Plan] purchases or sales; and, finally, (5) it must have been “entered into in good faith.” Moreover, a purchase or sale is not “pursuant” to a qualified Trading Plan if the trader “entered into or altered a corresponding or hedging transaction or position with respect to those securities” trading under the Plan. The SEC was well aware that the an affirmative defense to insider trading for those who execute their transactions through valid Trading Plans would (1) make it harder to detect insiders who hide their illegal trades by executing them through invalid Trading Plans that were adopted based on material nonpublic information, and would (2) provide a loophole in the law for others to strategically terminate otherwise valid Plans based on material nonpublic information. The SEC presumably decided that the evil of strategic use of Trading Plans was worth the prize of increased flexibility in enforcement that would come with the broad awareness test. In sum, the adoption of Rule 10b5-1 was, in a manner of speaking, a deal with the Devil that the SEC and some lawmakers now appear to regret having made. The problem is that, as is often the case with such deal, it cannot be easily undone. In this article, I identify challenges presented by the restrictions on Trading Plan use that Congress has proposed in the Corporate Insiders Act. In light of these challenges, I argue that effective Trading Plan reform cannot be accomplished by simply restricting the use of Trading Plans while leaving Rule 10b5-1(b)’s awareness test in place. If there is to be reform, it must be comprehensive. If neither the SEC nor Congress desires comprehensive reform of our current insider trading regime, however, I conclude by offering the consolation that permitting insiders to continue to use Trading Plans strategically may not be so bad after all. Perhaps even a deal with the Devil can be worked for the good of investors.