On Heels of Recent Rule Amendments, DOJ and SEC Target Purported 10b5-1 Trading Plan Abuse
A few months after the U.S. Securities and Exchange Commission (SEC) finalized amendments to address perceived abuses of corporate insider trading plans (known as "10b5-1 trading plans"), the U.S. Department of Justice (DOJ) filed its first-ever insider-trading action based solely on insider trades made pursuant to a 10b5-1 plan, in this case by the former CEO and Executive Chairman of Ontrak Inc. (Ontrak). Enforcement actions based on similar activity have been filed by the SEC in the past, but they remain rare, and the SEC's parallel action highlights its follow-through on its threats to target what it views as abusive 10b5-1 trading practices.
In this SECond Opinions post, we provide a brief overview of the recent 10b5-1 amendments, key highlights from the parallel SEC/DOJ actions and some important takeaways from the actions.
Rule 10b5-1: Overview and Recent Amendments
Rule 10b5-1 under the Securities and Exchange Act of 1934 (Exchange Act) provides an affirmative defense to corporate insiders that protects them from insider-trading liability provided they comply with certain conditions set forth in Rule 10b5-1(c). In order to avail oneself of the affirmative defense, the insider, among other things, must make a good-faith adoption of a trading plan prior to becoming aware of material, non-public information (MNPI). The prior version of the rule did not impose any "cooling off" period between the adoption of the plan and initial trading under the plan. Additionally, issuers were not required to disclose the existence of any 10b5-1 trading plans entered into by their officers and directors.
In response late last year to concerns that the rule was being abused, the SEC finalized amendments to Rule 10b5-1 to provide additional restrictions on the ability to avail oneself of the affirmative defense. Additionally, once effective, the new amendments will implement several new disclosure requirements for issuers. These requirements will generally go into effect in 2023, although the amendments will not impact existing 10b5-1 trading plans that were entered into prior to the effective date and are not later modified. Among the new requirements:
- Cooling-Off Periods: The amendments added a cooling-off period that requires a specified waiting period between adoption of the trading plan and any trading pursuant to the plan. The time period varies based on the insider's position within the company (the later of 90 days or two business days after the filing of Form 10-Q or 10-K for officers and directors1 and 30 days for other employees).
- Written Certifications: Officers and directors will now be required to provide a written representation certifying that he or she 1) is not aware of any MNPI about the issuer, and 2) is adopting or modifying the plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5. Although many brokerage firms already require similar representations, this obligation is now codified across the board.
- No Overlapping Plans: The Rule 10b5-1 affirmative defense is now generally unavailable for anyone (other than issuers) who have established multiple overlapping 10b5-1 trading plans during the same period.2 The granular aspects of the rule provide for certain exceptions, such as when there are no overlapping trades between the two plans and trading under the earlier plan concludes before the second plan begins.
- Only One Single-Trade Plan Per 12 Months: The Rule 10b5-1 defense for a single-trade plan – one in which an open-market sale or purchase of Company Securities is to be effected in a single trade – is available only if the insider has not had another single-trade plan within the previous 12 months.
- Modifications = New Plan: Any modifications to the amount, price or timing of the purchase or sale of the securities underlying a trading plan are now considered a termination of the existing 10b5-1 trading plan and the adoption of a new one.
- Good-Faith Requirement Expanded: Although a good-faith requirement existed under the prior iteration of the rules – specifically concerning entry of the plan – the amendments require insiders and issuers to now act in good faith with respect to the entire life cycle of the trading plan (including modifications). The SEC provided an example that would violate this new requirement: influencing the timing of an issuer's disclosure so that trades under a plan are more profitable.
- New Disclosures: Finally, the amendments added additional reporting requirements for issuers, directors and executive officers. Issuers will now have to provide quarterly reporting in their Forms 10-Q and 10-K regarding the use of trading plans by their directors and officers. For directors and officers, Section 16 reports on Forms 4 will require identification of any trade made under a Rule 10b5-1 trading plan. In addition, officers and directors will have to report any gift or donation of issuer securities on Form 4 within two business days after the gift. (Annual reporting of gifts on Form 5 has been eliminated.) For a more detailed assessment of the new 10b5-1 trading obligations, please see Holland & Knight's previous alert, "A Closer Look at the Rule 10b5-1 Amendments Adopted by the SEC," Dec. 22, 2022.
In adopting these amendments, the SEC noted its intent was to reduce the likelihood of potential abuse and promote investor confidence. Only a few months after adoption, the SEC – and, for the first time, the DOJ – filed actions alleging abuse of 10b5-1 trading plans.
Exemplary Allegations of Misuse Against a Corporate Insider
On March 1, 2023, the DOJ announced its first insider-trading prosecution based exclusively on trading pursuant to a Rule 10b5-1 trading plan. The DOJ indictment alleges that Terren S. Peizer, former CEO and executive chairman of Ontrak, sold Ontrak stock while in possession of MNPI that one of Ontrak's major customers was likely to cancel its contract. In a parallel civil enforcement action based on similar facts, the SEC announced civil charges against Peizer and Acuitas Group Holdings LLC (Acuitas), Peizer's investment vehicle.
The indictment alleges that Ontrak had an Insider Trading Policy (Policy) that applied to Peizer and prohibited trading based upon MNPI, which included information not available to the general public that had a reasonable likelihood to be considered important to an investor making a decision regarding the purchase or sale of Ontrak's securities. The Policy identified material agreements or terminations thereof as categories of information that should be considered material. It also required Peizer, prior to implementing a Rule 10b5-1 plan, to submit Pre-Trading Clearance Certifications to Ontrak's CFO that certified that the trading plan was not the result of knowledge of MNPI.
The allegations in the indictment concern Peizer's trading pursuant to two separate Rule 10b5-1 trading plans, allegedly done while he was in possession of MNPI that Ontrak was at serious risk of losing its contract with its then-largest customer. The indictment alleges that, as a result of his position at Ontrak, Peizer became aware between February 2021 and May 2021 of the increasing likelihood of losing the contract. This knowledge allegedly came on the heels of Ontrak having lost another of its largest customers, the public announcement of which caused Ontrak's stock price to drop nearly 46 percent. Notably, Ontrak's May 6, 2021, Form 10-Q stated that the loss of any of its four largest customers would have a material adverse effect on the company. The indictment alleges that despite all of this, Peizer visited with several brokers in early May to set up a Rule 10b5-1 plan to sell approximately $19 million worth of Ontrak stock, ultimately choosing a broker that did not require him to engage in a cooling-off period before the first trade. The indictment notes that the broker Peizer chose, while not requiring a cooling-off period, warned Peizer that failing to include one could create an appearance of impropriety and recommended to Peizer that the plan include one – a recommendation that Peizer allegedly declined to follow. The indictment alleges that, pursuant to Ontrak's Policy mentioned above, Peizer submitted the plan to Ontrak's CFO for approval, certifying that it was not the result of knowledge of MNPI.
Peizer allegedly entered into the plan through Acuitas, his personal investment company, and began selling shares pursuant to the plan on May 11, 2021. The indictment alleges that between May and July 2021, Peizer sold nearly $19 million worth of Ontrak shares through the plan, all while continuing to receive MNPI regarding Ontrak's purported impending loss of the contract. The indictment further alleges that on August 13, 2021, Peizer was informed by the individual leading the contract negotiations that the customer was likely to formally terminate the contract, and that on that same day, Peizer entered into a second Rue 10b5-1 trading plan, again without including a cooling-off period and with the same certification to Ontrak's CFO. Pursuant to this second plan, Peizer allegedly sold additional shares before Ontrak's August 19, 2021, public Form 8-k disclosure of the loss of the contract. Ontrak's stock price fell approximately 44 percent following the disclosure. The indictment thus alleges that Peizer avoided over $12 million in losses by entering into, and trading pursuant to, the two Rule 10b5-1 trading plans with knowledge of MNPI concerning the likely loss of the contract.
The SEC's complaint, which names both Peizer and Acuitas as defendants, makes similar allegations. The SEC alleges that both Peizer and Acuitas violated Sections 10(b) of the Exchange Act and Rule 10b-5 thereunder and 17(a) of the Securities Act of 1934.3 The complaint seeks injunctive relief, disgorgement, civil penalties, and a bar on Peizer from serving as an officer or director of a public issuer.
- Data-Driven Analytics Resulting in More Indictments/Enforcement Actions: As we have previously covered, the SEC has increasingly relied upon data-driven analytics to source, advance and ultimately finalize its insider-trading investigations. The SEC highlighted that this case arose from "a data-driven initiative into executive trading pursuant to 10b5-1 plans." In its release announcing the indictment, the DOJ noted that "[t]he investigation is part of a data-driven initiative led by the Fraud Section to identify executive abuses of 10b5-1 trading plans." As Deputy Attorney General Kenneth Polite noted in his remarks earlier this month at the ABA's 38th Annual National Institute on White Collar Crime, he expects more of these types of matters to follow.
- Pushing Boundaries on MNPI: Most practitioners would agree that knowledge of a major customer definitively canceling a key agreement would likely constitute MNPI. But what about a customer raising concerns about its relationship and the possibility of termination? This is far less certain. Possessing information about uncertain business terminations (or new agreements) falls squarely into a gray area. A materiality determination requires a delicate assessment of the inferences a reasonable shareholder would draw from the facts and is typically reserved for the trier of fact. Although the pre-trading plan communications alleged by both the DOJ and SEC (and other evidence) may ultimately establish materiality, it is likely that this determination will be made by a jury.
- Cooling-Off Periods in Focus: Under the newly adopted amendments, a failure to comply with cooling-off period requirements will result in a direct violation. Although many companies previously implemented these requirements on their own, the prior rules did not require a cooling-off period. Both the DOJ and SEC, however, specifically alleged that Peizer shopped for a broker that did not require a cooling-off period as part of its allegations of a fraudulent scheme, demonstrating an aggressive position to establish the necessary mental state. With new amendments coming into effect later this year, issuers and insiders should expect DOJ and SEC focus on these periods to only increase going forward.
- Another Compliance Area for Issuers to Revisit: The onslaught continues for issuers on the compliance front. From additional considerations on ephemeral messaging and employee clawbacks to new considerations around disclosure controls and procedures, issuer compliance policies are in a (seeming) constant state of reassessment. Given the impending effective dates, issuers should already be a in position to deal with the new 10b5-1 requirements, both concerning disclosure and employee obligations. But, as with many of the SEC's newly enacted and proposed rules, the new obligations will require issuers to engage in ongoing monitoring and reporting responsibilities.
The SECond Opinions Blog will continue to monitor the activity in this space and provide further updates. If you need additional information on this topic – or anything related to securities enforcement or investigations – please contact the authors or other members of Holland & Knight's Securities Enforcement Defense Team.
1 This period will not exceed 120 days following adoption or modification of the plan.
2 This restriction will not apply to "sell-to-cover" plans, where insiders instruct their brokers to sell securities to cover income-tax withholding obligations arising in connection with the vesting (and settlement) of certain compensatory equity awards provided the individual does not otherwise exercise control over the timing of such sales.
3 The complaint also brings an alternative cause of action against Peizer for Control Person Liability under Section 20(a) of the Securities Exchange Act for his role in controlling Acuitas' trading.