Lead Article: Implementing 10b5-1 Trading Plans After SEC Amendments and Peizer - July 2024

10b5-1 plans can be useful tools to facilitate permissible stock trading and financial planning for corporate insiders who are regularly in possession of material, nonpublic information (MNPI).  A properly designed 10b5-1 plan can rebut the presumption that an insider is selling shares in reaction to adverse corporate news that has yet to be publicly disclosed.  However, as a result of recent developments—namely, amendments to U.S. Securities and Exchange Commission (SEC) rules; increased scrutiny via a data-driven initiative led by the Fraud Section of the U.S. Department of Justice (DOJ) to root out abuses of 10b5-1 plans; a landmark trial conviction of a CEO on insider trading charges earlier this summer in United States v. Terren Peizer; and a Third Circuit decision last month affirming an asset freeze in SEC v. Dale Chappell, et al., while the SEC pursues disgorgement and civil penalties against an executive for alleged insider trading—companies should take a careful look at their insider trading policies, and executives should ensure they are complying fully with their 10b5-1 plans.

Below, we describe the SEC’s new rules regarding 10b5-1 plans and summarize the Chappell case and the Peizer case, which the acting head of the DOJ’s Criminal Division described as “the Justice Department’s first insider trading prosecution based exclusively on the use of a trading plan, but it will not be our last.”  DOJ Press Release (June 21, 2024), available at https://www.justice.gov/opa/pr/chairman-publicly-traded-health-care-company-convicted-insider-trading.  We also offer key takeaways for constructing future 10b5-1 plans.

December 2022:  SEC Amends the 10b5-1 Plan Safe Harbor

In August 2000, the SEC adopted Rule 10b5-1 under the Securities Exchange Act of 1934, which provided a safe harbor for a corporate insider to trade while in possession of material nonpublic information (MNPI) if the trading was executed under a prearranged written plan that was adopted in good faith at a time when the corporate insider was not in knowing possession of MNPI.  See SEC Fact Sheet Rule 10b5-1: Insider Trading Arrangements and Related Disclosures, available at https://www.sec.gov/files/33-11138-fact-sheet.pdf.  10b5-1 plans must be written to operate on autopilot by specifying the formula, algorithm, or predetermined price, quantity, and dates of future securities transactions; these cannot be subject to future discretion. 

In response to comments from “courts, commenters, and members of Congress that insiders have sought to benefit from the rule’s liability protections while trading securities opportunistically,” on December 14, 2022, the SEC adopted amendments to Rule 10b5-1 to promote confidence in the markets and strengthen protections for investors against insider trading.  See SEC Press Release (Dec. 14, 2022), available at https://www.sec.gov/news/press-release/2022-222.  The modifications require, among other things: (1) waiting periods (commonly referred to as “cooling-off” periods), for directors, officers, and persons other than issuers, before trading can begin under a 10b5-1 plan; (2) annual disclosures concerning the company’s insider trading policies and procedures or an explanation for why the policies and procedures have not been adopted; (3) quarterly disclosures concerning the use of 10b5-1 plans; (4) updates to Forms 4 and 5 (required filings for certain securities transactions) that require certification that the subject transaction was executed under a 10b5-1 plan along with identification of the date of the plan’s adoption; (5) representations by directors and officers that such plans were adopted in good faith and at a time when the directors and officers were not in possession of MNPI; and (6) a condition that all persons entering the 10b5-1 plan will act in good faith under that plan.  See id.; see also SEC Fact Sheet Rule 10b5-1: Insider Trading Arrangements and Related Disclosures, available at https://www.sec.gov/files/33-11138-fact-sheet.pdf.  The amendments also limit the use of multiple, concurrent 10b5-1 plans by persons other than the issuer and limit anyone other than an issuer to a single 10b5-1 plan per twelve-month period.  Id.  The foregoing requirements, which went into effect in 2023, post-date the 10b5-1 plans at issue in Peizer and Chappell discussed below.

June 2024:  Peizer Convicted for Insider Trading Under 10b5-1 Plan

On June 21, 2024, in the first-ever criminal prosecution of insider trading based entirely on the use of a 10b5-1 plan, a federal jury in Los Angeles, California convicted Terren Peizer on one count of securities fraud and two counts of insider trading.  See DOJ Press Release (June 21, 2024), available at https://www.justice.gov/opa/pr/chairman-publicly-traded-health-care-company-convicted-insider-trading.  Peizer was the former CEO, executive chair, and chair of the board of directors of a publicly traded health care company, Ontrak Inc. 

The prosecution presented evidence that Peizer sold Ontrak shares under two 10b5-1 plans that were adopted when Peizer was aware of MNPI—specifically, that Ontrak’s largest client, Cigna, was poised to terminate a $90 million deal for Ontrak to provide services to certain of Cigna’s plan customers.  See Craig Clough, Ontrak Founder Convicted in Novel Insider Trading Case, Law360 (June 21, 2024), available at https://www.law360.com/articles/1850416.  In May 2021, Peizer adopted a 10b5-1 plan to sell shares shortly after learning that the relationship between Ontrak and Cigna was deteriorating, and that Cigna had expressed serious reservations about continuing its contract with Ontrak. See DOJ Press Release (June 21, 2024), available at https://www.justice.gov/opa/pr/chairman-publicly-traded-health-care-company-convicted-insider-trading.  In August 2021, Peizer adopted a second 10b5-1 plan to sell shares within minutes of being informed by an Ontrak employee engaged in the contract negotiations that Cigna would likely terminate the deal.  See id.  Against the advice of brokers, a compliance officer, and attorneys, Peizer decided against any cooling-off period and instead commenced selling Ontrak shares the day after each plan was adopted.  See id.  Six days after the second 10b5-1 plan was adopted, the company publicly announced the contract’s termination and the share price dropped by over 44%.  See id.  By selling prior to the announcement, Peizer avoided over $12.5 million in losses.  See id.  

At trial, Peizer’s defense counsel argued that Peizer had relied on his management team’s determination that he did not possess MNPI before he had entered the trading plans and that, by engaging in the transactions, “Peizer simply wanted to exercise warrants about to expire, pay off some loans and purchase a house.”  See Craig Clough, Ontrak Founder Convicted in Novel Insider Trading Case, Law360 (June 21, 2024), available at https://www.law360.com/articles/1850416.  In particular, Peizer’s defense said that Ontrak’s chief financial officer had signed off on his use of the plans.  The jury rejected that defense, finding that the prosecution’s evidence conclusively established Peizer’s intent to trade unlawfully.

Peizer now faces a maximum prison sentence of 20 years for each count of insider trading and 25 years for the securities fraud count.  His sentencing is scheduled for October 2024.    

July 2024: Third Circuit Affirms Asset Freeze for Trading Under 10b5-1 Plan

On July 9, 2024, the Third Circuit affirmed a district court’s ruling freezing the assets of Dale Chappell, the Chief Scientific Officer and a board member of Humanigen Inc., a public company, to prevent Chappell from concealing or transferring assets that could be subject to disgorgement or civil penalties for insider trading under a 10b5-1 plan.  Sec. & Exch. Comm’n v. Chappell, No. 23-2776, 2024 WL 3335652, at *5 (3d Cir. July 9, 2024).  In the wake of COVID-19, Humanigen applied for emergency use authorization (EUA) from the U.S. Food and Drug Administration (FDA) to launch its only drug with near-term revenue potential for treating inflammation in COVID-19 patients.  See id. at 4-5, 14.  While Humanigen awaited a decision on the EUA application, Chappell adopted two 10b5-1 trading plans: the first, in March 2021, set limit prices higher than the current market price of Humanigen stock; the second, in June 2021—at a time when the SEC argued Chappell was in possession of MNPI that the FDA would not grant an EUA unless Humanigen performed an additional confirmatory study that the company resolved not to undertake—set limit prices that were lower than the current market price of Humanigen stock.  See id. at 2-3 & n.6.  The June 2021 plan was approved by the CFO, but the record did not reflect the basis for approval.  See id. at *3.  In September 2021, Humanigen announced the FDA’s EUA denial, and the stock fell by nearly 50%.  See id. at *4-5.  Chappell’s trades prior to the announcement, including under the June 2021 trading plan, allowed him to avoid $38 million in losses.  See id.  The SEC commenced an investigation, and upon its application, the district court issued an order freezing Chappell’s assets.

In affirming the asset freeze, the Third Circuit upheld the district court’s determination that the SEC had shown a likelihood of success on the merits.  In particular, the SEC had established a likelihood that the interim FDA feedback was tantamount to a final agency decision and was material because the subject drug of the EUA request was a “bet-the-company product,” the FDA made clear that the drug would not get an EUA without a confirmatory study, Humanigen submitted the EUA request before it planned for or completed the requisite study, and Humanigen’s CFO and compliance officer thought the FDA feedback warranted disclosure.  Id. at *12, 14.  The Third Circuit also found that the district court did not err in finding that the SEC had established Chappell’s scienter.  Chappell had “no good answer for the damning evidence of a sudden shift in pricing and volume between his March and June plans, a change that came after the FDA provided its feedback.”   Id. at *15.  Chappell’s rejoinder that he had spoken with brokers about selling shares before the FDA discussions did not “explain why, especially if he believed that [the drug] was about to get EUA approval, he decided to sell shares at a discount after the FDA feedback, when he was previously willing to sell them only at a premium.”  Id. at *16.  Nor was the Third Circuit persuaded by Chappell’s argument that the March 2021 premium was based on a bullish forecast, because that argument failed to explain why he would not also be bullish in June 2021 unless he viewed the FDA feedback as negative.  Id. 

With the freeze affirmed, the SEC will continue its efforts to seek disgorgement of ill-gotten gains, interest, civil penalties, and an order barring Chappell from serving as an officer or director of any publicly traded company.  See id. at *5.               

Key Takeaways in Constructing Future 10b5-1 Plans

1. Continued and Increased Scrutiny. Perhaps the most important takeaway from these recent decisions is that pre-set trading plans under 10b5-1 can provide an affirmative defense but are not an absolute shield from insider trading liability.  The DOJ has said publicly that the Peizer case was “part of a data-driven initiative led by the Criminal Division’s Fraud Section to identify executive abuses of 10b5-1 trading plans.” DOJ Press Release (June 21, 2024), available at https://www.justice.gov/opa/pr/chairman-publicly-traded-health-care-company-convicted-insider-trading.  It is inevitable that more cases will be brought under this initiative.  The DOJ (and the Fraud Section in particular) for years has been proactive about using securities and commodities trading data to identify suspicious trading patterns for investigation and possible prosecution.  In light of the Peizer conviction and the Chappell case, we can expect to see other investigations, civil enforcement actions, and potentially criminal prosecutions of insider trading pursuant to 10b5-1 plans.
2. Insider Trader Policies. Given the heightened scrutiny, public companies and corporate insiders should consult with counsel to evaluate insider trading policies and 10b5-1 plans and update their policies and plans as necessary to comply with the SEC’s amendments to Rule 10b5-1.  Adopting and strengthening insider trading policies is recommended, particularly in light of the now-mandatory annual disclosures.  One way to strengthen insider trading policies would be to require and specify a 10b5-1 preclearance process that involves internal counsel and compliance officers.  It can also be helpful to set predetermined periods when 10b5-1 plans can be adopted.  The window should be set for a time when corporate insiders are least likely to possess MNPI.  Alternatively, the insider trading policies can specify blackout periods—e.g., beginning before the quarter ends and extending until the quarter’s earnings announcement when corporate insiders are most likely to possess MNPI—when plans cannot be entered.
3. Volume Limitations. Consider including a volume maximum in 10b5-1 plans.  Peizer sold hundreds of thousands of shares on a daily basis under his 10b5-1 plan.  See Craig Clough, Ontrak Founder Convicted in Novel Insider Trading Case, Law360 (June 21, 2024), available at https://www.law360.com/articles/1850416/print?section=corporate.  And Chappell sold 3,835,000 shares in a roughly two-month span under his 10b5-1 plan.  Sec. & Exch. Comm’n v. Chappell, No. 23-2776, 2024 WL 3335652, at *4.   Now that the DOJ is using data analytics to monitor 10b5-1 trading, large-volume transactions in a short time period will likely be flagged.  Setting relatively modest volume restrictions that limit sales to a specified daily percentage can help combat suspicion of opportunistic trading and avoid signaling to the market that the insider is selling because of negative news or to a lack of confidence in the issuer.
4. Simplicity. Because the SEC now requires quarterly disclosures regarding the use of 10b5-1 plans, it will be helpful to design simple 10b5-1 plans.  Any plan should make clear that the covered transactions’ date, quantity, and price are set by formula, algorithm, or some other predetermined mechanism and are not subject to future discretion.  Note that, as in Chappell, any dramatic shifts in volume and/or pricing between consecutive trading plans can lead to suspicion or increased scrutiny.
5. Plan Length. The SEC now limits persons other than the issuer to one 10b5-1 plan per 12-month period.  Accordingly, when constructing a plan, consider what needs to be accomplished during the full 12 months as the plan cannot be modified until the close of that period.  Financial goals, vesting periods, expiration dates, and other factors should be considered not only for the 12-month period of the subject trading plan but also for the time period before the next plan can take effect.  Generally, longer plans are less likely to raise suspicion than shorter plans.  However, corporate insiders will need to plan around the new mandated cooling-off periods.  Unlike the situation in Peizer, cooling-off periods are no longer optional.  Before trading under a plan, directors and officers must wait either 90 days after a plan is adopted or two business days after disclosure of the issuer’s financial results for the quarter in which the plan was adopted or modified (but not to exceed 120 days), whichever is later.  See SEC Fact Sheet Rule 10b5-1: Insider Trading Arrangements and Related Disclosures, available at https://www.sec.gov/files/33-11138-fact-sheet.pdf.  Persons other than directors, officers, or the issuer must wait 30 days before trading under a plan.  Id.  Although cooling-off periods are helpful to rebut the notion of opportunistic trading, a 90- to 120-day cooling-off period can be up to four times the 30-day length that typically was recommended prior to the new rules.  Accordingly, this lengthy mandated cooling-off period for directors and officers may decrease the utility derived from 10b5-1 plans.

6.         Existence of MNPI.  Peizer presented evidence that he relied on his management team that there was no MNPI at the time he entered his 10b5-1 plans.  See Craig Clough, Ontrak Founder Convicted in Novel Insider Trading Case, Law360 (June 21, 2024), available at https://www.law360.com/articles/1850416.  That evidence did not persuade the jury.  Similarly, that Chappell’s CFO preapproved his trading plan did not persuade the Third Circuit, particularly when the basis for the approval was absent from the record.  Insiders thus should consider documenting in some fashion the extent of even potentially material information (if any) known to them at the time they enter into a 10b5-1 plan, disclosing that information to a corporate compliance officer or attorney for an informed determination and clearance, and documenting the rationale for clearance.  Following this procedure can bolster the representation required of directors and officers that 10b5-1 plans were entered in good faith and at a time when the directors and officers were not in possession of MNPI.