Judges Should Scrutinize Trading Plans’ Use as Fraud Defense

When company executives sell their own shares at prices inflated by misrepresentations, it rightfully triggers an inference that those sales reflect a motive to commit fraud. Defendants in securities fraud cases frequently rely on “trading plans” entered into under Rule 10b5-1 of the Securities Exchange Act, which create preset transaction schedules, to rebut a finding of motive.

Legitimate concerns about the validity of this defense were borne out in a June jury verdict against the former CEO of Ontrak Inc. and reflected in the Securities and Exchange Commission’s expanded regulations for more detailed disclosures on trading plans. Courts in civil cases should follow these concerns and severely constrain the application of trading plans as a defense in securities fraud cases.

Rule 10b5-1 trading plans “allow corporate insiders to set a schedule by which to sell shares over time.” Trading plans frequently feature in private securities litigation, where plaintiffs allege that insiders were motivated to make “a misrepresentation in order to sell their own shares for a profit” while the share price was inflated due to their fraud. By claiming that any sales alleged by the plaintiffs were conducted pursuant to these trading plans and not at the defendants’ discretion, the defendants attempt to “raise an inference that the sales were prescheduled and not suspicious.”

As some courts have observed, this defense shouldn’t be absolute, given that the trading plans might be “entered into or strategically amended to take advantage of an inflated stock price or insider information,” according to a 2021 ruling in the Southern District of New York. The conviction of former Ontrak CEO Terren Peizer for insider trading offers a prime example of how unscrupulous insiders might use their trading plans.

As a press release on the verdict explained, Peizer “set up Rule 10b5-1 trading plans to sell shares before [negative] news became public and to conceal that he was trading on insider information.” The conviction underscores that 10b5-1 plans can be used to implement fraud and shouldn’t broadly create a defense as to motive.

Adding to the problem was the reality that Rule 10b5-1 plans were often not disclosed or only vaguely described. Aware of the potential for their abuse, the SEC in late 2022 adopted rule changes designed to increase Rule 10b5-1 plans’ transparency.

Before the changes, corporate insiders didn’t need to publicly file any basic details of the plans, including when they entered into them. But under the revisions, companies must disclose any trading plans entered into by insiders during the prior quarter and the material terms of those plans. Insiders disclosing stock transactions also must indicate if the transaction was pursuant to a trading plan and, if so, the date of the plan.

These revisions are a step in the right direction, and securities fraud plaintiffs should use this increased transparency to probe whether the mere existence of a trading plan indicates insiders lacked motive to commit fraud.

Unfortunately, many judicial decisions pre-dating the 2023 disclosure changes relied on opaque information about trading plans to conclude that the existence of a trading plan negated an inference of motive. Those cases are often cited as orthodoxy and present a challenge to plaintiffs even in cases where details of the plans should mitigate or eliminate the application of a trading plan as a defense.

Using the enhanced disclosures now required, plaintiffs’ counsel should review quarterly filings during the time period at issue to determine whether any defendants entered into trading plans after they made misrepresentations. The plans, especially if developed close in time to alleged misrepresentations, might show that insiders used a 10b5-1 plan to offload shares while the price was inflated. Such facts would support a fraudulent motive rather than rebut it.

However, even where the trading plans predate any misrepresentations, neither plaintiffs nor courts should assume that the plans’ mere existence forecloses motive. The US Court of Appeals for the Tenth Circuit explained in a 2022 case that “a defendant who knows the schedule of their 10b5–1 plan could be motivated to make material misrepresentations affecting the stock price to their benefit before a scheduled sale or to trigger a sale at a particular price.”

This is an obvious observation, but a critical one—executives know the pattern of their trading plans and can still exploit the schedule to profit from non-public information. Plaintiffs can further challenge existing case law that credits trading plans as a defense by connecting the timing of misrepresentations to any scheduled sales.

Courts, for their part, should credit such motive allegations and, given the plans’ potential for abuse, carefully scrutinize the provisions of any Rule 10b5-1 trading plan put forth by defendants before finding that it negates an inference of motive.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

James A. Harrod is partner at Bernstein Litowitz Berger & Grossmann with experience prosecuting complex litigation in federal courts, representing institutional investor clients in securities fraud-related matters.

Timothy G. Fleming is an associate at Bernstein Litowitz Berger & Grossmann with focus on securities fraud, corporate governance, and shareholder rights litigation on behalf of institutional investor clients.

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