Red Flags Everywhere! – Ten Risks for Directors – Week 5

Each week for the next 10 weeks, we will publish an installment of our Red Flags Everywhere! series, highlighting key risk areas that public companies and their boards of directors should keep top of mind.

This series will serve as a lead up to MoFo’s upcoming Red Flags and Red Wine Tabletop program taking place in our Palo Alto office on May 7. Members of our Securities Litigation, Employment and Labor, and Capital Markets Groups will guide attendees through a ripped-from-the-headlines fact pattern designed to spark interactive discussion and practical analysis that will be valuable to every board advisor.

This week, we focus on insider trading and Rule 10b5-1 plans. These plans can provide protection from insider trading liability, but only if they are properly implemented and followed.

If you are interested in learning more about MoFo’s Red Flags and Red Wine Tabletop event, please reach out to Deborah Argueta. See all the Red Flags client alerts.

Rule 10b5-1 Plans and Insider Trading Policies Should Be Real, Current, and Enforced

Directors—even outside directors—are considered “corporate insiders” and are therefore subject to strict legal regulations regarding trading in company stock based on material nonpublic information (“MNPI”). Strong insider trading policies and carefully administered Rule 10b5-1 trading plans can provide meaningful protection against insider trading claims, but only if they are properly implemented, consistently followed, and disclosed appropriately. Recent SEC enforcement actions and even criminal prosecutions demonstrate that the government can and will challenge abuses of Rule 10b5-1 trading plans. This alert provides practical tips for proper implementation of Rule 10b5-1 trading plans to help mitigate risk.

What Is Insider Trading?

The misappropriation theory of insider trading refers to buying or selling a public company’s securities while in possession of MNPI in violation of a duty of trust and confidence. Information is considered “material” if there is a substantial likelihood that it would be viewed by a reasonable investor as having significantly altered the total mix of information available to the investor before making the purchase or sale. That kind of information can be either good news or bad news. 

Examples include:

• a material change in expected earnings (up or down);
• a proposed public or private securities offering;
• a loan default or other major financial problem;
• a pending or proposed merger, acquisition, joint venture, sale of major assets, or other strategic deal;
• major regulatory developments, patent approvals, government investigations, or significant litigation;
• a change in management;
• a new product announcement; and
• the gain or loss of a significant customer, supplier, or business partner.

Information is “nonpublic” until it has been broadly shared with the market and investors have had enough time to absorb it. As a general rule, information should be treated as nonpublic until the start of the second business day after it is publicly released, such as through a press release or an SEC filing. For example, if the company announces something on Monday, you should usually treat it as public starting on Thursday.

What Are Rule 10b5-1 Plans?

Rule 10b5-1 plans are intended to provide companies and corporate insiders with a defense to accusations of insider trading and an avenue to purchase or sell stock. This defense is potentially available only if the corporate insider is not in possession of MNPI at the time the plan is established. These plans allow insiders to set up trades in advance—for example, to buy or sell a predetermined number of shares at a predetermined time. If the Rule 10b5-1 plan is adopted before the insider possesses MNPI, later trades under the plan are less likely to be viewed as improper, even if the trades coincide with corporate blackout periods—since the trading decisions were made before the restriction.

After the SEC created rules for Rule 10b5-1 plans over two decades ago, companies have widely adopted such plans. The plans can be especially important for officers and directors seeking to monetize equity awards.

In 2022, the SEC amended Rule 10b5-1 to introduce mandatory “cooling-off” periods, requiring that insiders wait a set amount of time after establishing the plan before starting trades under the new plan. For officers and directors, the cooling-off period is the later of 90 days after plan adoption or modification, or two business days following the filing of the Form 10-Q or 10-K for the quarter the plan was adopted.

Directors and officers must also now attest that, at the time they are entering into a Rule 10b5-1 plan, they are not aware of MNPI and that they are adopting the plan in good faith and not as part of a scheme to evade the prohibitions of Rule 10b-5. Further, individuals must act in good faith with respect to the plan for its duration (e.g., not timing the release of MNPI to influence trades under a Rule 10b5-1 plan).

Notable Insider Trading Cases for Directors

When insider trading allegations arise, the fight is often not just about what happened, but about how it looks in hindsight. Private plaintiffs, regulators, and the press will reconstruct a narrative around who knew what, when they knew it, why a trade occurred when it did, and whether the company had real safeguards in place. That is why strong insider trading policies, effective internal controls, and disciplined Rule 10b5-1 administration matter so much. Good controls help prevent bad trades, but they also help explain legitimate ones.

Recent enforcement actions underscore the point. We recently covered securities enforcement trends in this area.[1]

• United States v. Peizer
  
  On June 21, 2024, a jury in California federal court convicted Terren Peizer, the former CEO, executive chair, and chair of the board of directors of Ontrak Inc., a public healthcare company, of one count of securities fraud and two counts of insider trading. This was the first-ever criminal insider trading case based solely on trades placed pursuant to a Rule 10b5-1 trading plan. We previously wrote about the trial and the conviction.[2]
  
  
  DOJ alleged that Peizer avoided more than $12.5 million in losses by entering into, and then trading pursuant to, two Rule 10b5-1 trading plans while allegedly in possession of MNPI that Ontrak’s largest client would terminate its relationship with the company. At the trial, the government presented evidence that Peizer entered into his first 10b5-1 trading plan shortly after learning that the relationship between Ontrak and its largest customer was deteriorating. A few months later, Peizer entered into his second 10b5-1 trading plan minutes after Ontrak’s chief negotiator for the contract told Peizer that the contract likely would be terminated. Following establishment of each trading plan, Peizer began selling shares of Ontrak on the next trading day. Just six days after Peizer adopted his second 10b5-1 plan, Ontrak announced that the customer had terminated its contract, and Ontrak’s stock price declined by more than 44%.
• SEC v. Panuwat
  
  On April 5, 2024, a jury in California federal court found a former corporate executive liable for insider trading in SEC v. Panuwat. This enforcement action involved a theory known as “shadow trading”—where an insider uses MNPI about his or her own company to trade securities of another company, such as a competitor or peer company in the same industry, in violation of prohibition against doing so. We previously wrote about the trial and the verdict.[3]
  
  
  The SEC alleged that Matthew Panuwat, a former senior director of business development at Medivation, a publicly traded biopharmaceutical company, committed insider trading based on his confidential knowledge that Medivation would soon be acquired. Panuwat, however, did not trade the securities of Medivation. Instead, Panuwat allegedly purchased short-term out-of-the-money call options of Incyte, a biopharmaceutical company that was not involved in the acquisition, seven minutes after he received an email from Medivation’s chief executive officer stating that Medivation would be acquired. Panuwat turned on the expansive insider trading policy of the company where the defendant was employed. Medivation’s insider trading policy prohibited Medivation insiders from trading in other companies’ securities based on MNPI gained during their Medivation employment. The SEC alleged that confidential information about the acquisition of Medivation was material to Incyte investors because Medivation and Incyte were comparable companies in a mid-cap industry sector that was the subject of potential acquisitions. In other words, it was reasonable to infer that the acquisition of Medivation could affect the stock price of Incyte. 
  
  Shortly after the Medivation acquisition, the stock price of Incyte increased, and Panuwat made more than $100,000 in profits from the Incyte options.
  
  At trial, Panuwat defended his actions by testifying that he purchased Incyte options based on an analyst report that he had read a month earlier and that his purchase was unrelated to his knowledge of the Medivation acquisition.
  
  Following an eight-day trial and three hours of deliberations, the jury found Panuwat liable.
• SEC v. Gupta
  
  An older case, but still noteworthy for directors, in July 2013, the SEC obtained a $13.9 million penalty against former Goldman Sachs board member Rajat Gupta for illegally tipping corporate secrets to former hedge fund manager Raj Rajaratnam.[4] Gupta was also permanently barred from serving as an officer or director of a public company. The SEC alleged that Gupta disclosed confidential information to Rajaratnam about Berkshire Hathaway Inc.’s $5 billion investment in Goldman Sachs as well as nonpublic details about Goldman Sachs’ financial results for the second and fourth quarters of 2008. One of Gupta’s primary defenses was that he did not personally trade in the securities or share in any profit or personal benefit from Rajaratnam’s trades. The jury and the Second Circuit rejected this defense. The Second Circuit held that intangible benefits—such as maintaining a good relationship with a business partner—were sufficient to support Gupta’s conviction for tipping. 

Key Takeaways for Directors

Given the prospect of both enforcement and stockholder litigation, here are four practical steps directors should consider:

1. Adopt an insider trading policy that is broad enough to match today’s risk.

Companies should tailor their insider trading policies to address their business model and known risks. Polices should expressly prohibit tipping and apply to directors, officers, employees, household members, and controlled entities. In addition, a company may wish to adopt a policy that does more than ban trading while aware of MNPI about the company, and extend prohibitions to trading in other companies’ securities.  For example, a policy may ban trading in companies with whom the company has a material relationship or are industry competitors, based on MNPI learned in the course of one’s employment. As companies continue to value board members in operating roles and within the same or adjacent industries, access to confidential information that implicates “shadow trading” is prevalent, and the definition of MNPI may need to evolve. Panuwat is the clearest cautionary example of why this matters. A policy that speaks only to the issuer’s stock may leave a gap.

2. Make Rule 10b5-1 administration a real compliance process, not a convenience.

The company should require preclearance for the adoption, modification, suspension, and termination of any Rule 10b5-1 plan. Plans should be adopted only during open windows and only after a careful assessment that the insider is not aware of MNPI. The company should also treat cooling-off periods, certifications, overlapping-plan restrictions, single‑trade-plan limits, and the ongoing good-faith requirement as operational controls rather than technicalities. Properly administered plans can help remove timing discretion from the insider and create a record showing that trades were planned before later events occurred.

3. Use the policy and the plan process to reduce the risk of later accusations.

A good policy and a good plan do more than prevent violations; they help explain legitimate conduct after the fact. If a director sells during a volatile period, the company will want to be able to show that the trade was made pursuant to a precleared plan adopted before the director possessed MNPI, after the required cooling-off period, and subject to the company’s normal controls.

4. Train regularly, control information flow, and document the process.

Policies work only if directors internalize them. Boards should receive periodic reminders that confidential information belongs to the company, not to the individual director; that no one should forward sensitive materials, discuss board matters casually, or hint to family members, friends, or business associates; and that questions should be escalated promptly to the general counsel or chief compliance officer. The Gupta matter illustrates the stakes when confidential board information is shared outside the boardroom. And because later disputes often turn on process, the company should maintain a defensible record of preclearance decisions, blackout periods, plan approvals, plan modifications, and related communications.

A final practical point: insider trading policies and Rule 10b5-1 plans should not be viewed as boxes to check in calm times. They matter most when the company is in the middle of something sensitive—an acquisition, an earnings miss, a regulator inquiry, a leadership change, or an operational setback. Those are exactly the moments when director trading will attract scrutiny. A board that has invested in a broad policy, disciplined Rule 10b5-1 administration, targeted training, and careful documentation will be in a much better position both to prevent misconduct and to defend against the accusation that an otherwise lawful trade was something more.

The prior Red Flags alerts are available here:

• Week 1: Director Oversight of AI Requires Strong Processes and Good-Faith Engagement
• Week 2: Board Engagement with Political and Social Issues Should Be Tied to Stockholder Value
• Week 3: Board Refreshment and Director Risk: Navigating Investor Demands and Delaware Constraints
• Week 4: Board Oversight of the CEO Should Be Active and Independent

[1] When Your Life Sciences Are on the Line: Securities Enforcement.

[2] Takeaways for In-House Counsel from DOJ’s First Insider Trading Trial Involving a Rule 10b5-1 Plan.

[3] Takeaways for In-House Counsel from the SEC’s “Shadow Insider Trading” Trial.

[4] SEC Obtains $13.9 Million Penalty Against Rajat Gupta.