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Potential abuse by corporate insiders of programmed stock trading plans has caught the attention of the Securities and Exchange Commission and rattled the nerves of corporate boards, which are scrambling to make sure the plans pass muster. A 2000 SEC rule change allowed corporate officers, directors and other insiders to create stock trading plans under SEC Rule 10b5-1, which spread stock trades over a prearranged period, to insulate officers from potential claims of illegal trading on inside knowledge. Although the typical practice is to design a plan and then leave it alone, some executives may have stretched the rules, slipping in and out of their trading plans or terminating them � once again opening officers and their companies to insider trading claims. Some of the current jitters were triggered by the informal SEC investigation of Countrywide Financial Corp. executive Angelo Mozilo, who allegedly tinkered with his 10b5-1 plans as the mortgage market disintegrated. “I have been fielding a number of questions, including whether boards should evaluate the plans,” said Melinda Haag, a white-collar defense lawyer in Orrick, Herrington & Sutcliffe’s San Francisco office. And in October, former Qwest Communications International Inc. Chief Executive Officer Joseph Nacchio, who was convicted of insider trading in April by a Denver jury, appealed his conviction, calling the prosecution claims unprecedented. The government argues that Nacchio knew as long as eight months in advance that Qwest might not meet year-end financial projections, and thus could be held liable for his stock trades, argues the appeal by Maureen Mahoney of Latham & Watkins’ Washington office. The latest round of boardroom handwringing follows months of speculation about whether the SEC would bring enforcement actions for alleged 10b5-1 plan abuses. So far, nothing has materialized. “The problem with 10b5-1 plans is executives think they are more protective than they are,” said Joseph D. Edmondson, an attorney in Foley & Lardner’s Washington office. “They are not intended as a safe harbor. They are an affirmative defense,” said Edmondson. “It raises a concern any time someone wants to change a plan; It raises the question what did they know at that time [of the change],” Edmondson said. Stay tuned to the Nacchio case � it raises the potential that executives may never be fully cleansed of inside information, he said. Complicating matters, the SEC does not require disclosure of the existence of 10b5-1 plans. The plans can be created and sold to executives by brokerage firms � rather than written by corporate counsel. Nor are boards required to collect the plans and monitor whether executives adhere to them. But as a practical matter, companies have insider trading policies and a general duty to supervise employees, said Priya Cherian Huskins, an attorney with insurer Woodruff-Sawyer & Co., which provides directors and officers insurance against just such issues. Companies have compliance officers who must clear stock trades by insiders, she said. “But at the end of the day, the responsibility rests with the individual insider,” she said. “They still must comply.” The SEC adopted Rule 10b5-1 seven years ago to alleviate a split in the circuits concerning the level of proof required to show an officer traded with the benefit of inside information. The SEC wanted a lower standard of proof to allow a more aggressive pursuit of insider trading. It wanted to assert a presumption that mere possession of such information could render stock sales improper. As a tradeoff, Rule 10B5-1 creates a narrow affirmative defense to rebut insider trading claims. It establishes a trading program before the executive has specific inside information and generally identifies specific trading times involving smaller blocks of stock. This allowed company officers to sell stock without being exposed to criminal allegations of insider trading, to expand trading windows into periods normally closed to them and to curtail the ability of the plaintiffs’ bar to allege insider trading in securities class actions. Then in March, Alan Jagolinzer, a Stanford University School of Business professor, found that, despite the existence 10b5-1 plans, 3,200 executives in 1,200 firms were able to outperform their peers who trade without use of the plans by 6%, when there should have been no statistical difference. This caught the attention of the SEC’s top enforcer, Linda Chatman Thomsen, who said at the time, “We’re looking at this � hard. We want to make sure that people are not doing here what they were doing with stock options.” Last week, Walter Ricciardi, Thomsen’s deputy director of enforcement, refused to discuss specific investigations, but said, “We do have certain concerns that people may abuse the plans by trying to modify them. We look at that. We’re trying to stay on top of it.” But not everyone is convinced the SEC has the bite to back up its bark. “Part of what is going on is the staff at the SEC is carrying a big stick without a lot behind it,” said Boris Feldman, a securities litigation specialist at Wilson Sonsini Goodrich & Rosati in Palo Alto, Calif. He said the composition of the SEC commissioners has changed and is more heavily Republican. “The staff may want to bring actions, but I am not sure the commissioners will back it,” he said. Feldman said he had a private case that resolved without action, despite initially intense SEC scrutiny. “I believe 10b5-1 plans remain very safe and a very good way to diversify, if [executives] don’t get cute,” he said. The most effective plans are plain vanilla trading instructions to sell vested shares within a specific time. On the other extreme, if an executive amends a plan frequently or pegs trades to stock-price movement, that is not safe, he said. “The SEC will argue it is part of a scheme to maximize trading value,” Feldman said. “We’re still in a period of learning,” said Todd Henderson, a University of Chicago law professor who is working on a follow-up study with Jagolinzer. “When Thomsen gives a speech like that, it tells academics, ‘Go study this.’ And it signals to firms, ‘We’ve given you a tool and we’re not sure how you’re manipulating it, but be careful,’ ” he said. Whether a board should conduct some inquiry depends on the facts; for example whether there is extensive use of 10b5-1 plans by its executives, according to Orrick’s Haag. “One interim step would be to collect plans and conduct analysis of trading inside and outside the plans,” she said. The biggest draw of the plans is not the defense to criminal liability, but that they allow the vast majority of executives to trade during periods in which they would traditionally be blacked out, and the ability to avoid securities class action liability. But courts have just begun to take 10b5-1 plans into account in motions to dismiss. In 2006, a federal judge in Ohio held it was premature to consider a 10b5-1 plan at the motion to dismiss stage. In re Cardinal Health Inc., 426 F. Supp. 2d 688 (S.D. Ohio 2006). A federal judge in Georgia, however, denied a motion to dismiss, despite noting the existence of a 10b5-1 plan and its use as an affirmative defense. The unpublished ruling noted that 10b5-1 plan could give rise to uses by a clever trader able with insider knowledge to maximize stock gains in a way that is disguised in a 10b5-1 plan. In re Immucor Inc., 2006 WL 3000133 (N.D. Ga.). And a federal judge in Texas told plaintiffs in a securities class action they should have addressed disputed terms and alleged abuse of a 10b5-1 plan in the complaint itself, dismissing the case for potential amendment. Fener v. Belo Corp., 425 F. Supp. 2d 788 (N.D. Texas 2006).

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