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Psst! Want a hot stock tip? Starting Monday, a little-noticed Securities and Exchange Commission rule will permit employees to legally trade their company’s shares even if they are aware of material inside information. The catch: Trades must be made under a written plan created before the insider knew of the stock-sensitive development. Although Rule 10b5-1 received little fanfare when it was adopted in August, many predict it will have far-reaching consequences. “It is a tremendously significant rule,” said Donna M. Nagy, a professor at the University of Cincinnati College of Law. She noted that it is the first time the SEC has used its rulemaking power to define insider trading, “after a decade of being asked” to do so. The rule could be a boon for corporate executives and employees of smaller companies whose trading activity is restricted to “windows of opportunities” imposed by the company. Many corporations forbid senior executives from buying or selling company stock during a period that generally extends from two to four weeks before the end of a quarter until a few days after the financial statements have been publicly released. Beyond that, companies will shut trading windows because of a merger or acquisition, agency approval of a company product, results of a clinical trial or other event that may affect the stock price. In the relaxed atmosphere of smaller and start-up companies, “where typically everyone knows what’s going on,” even lower-level employees may be subject to trading restrictions, said David M. Furbush, a partner at Brobeck, Phleger & Harrison LLP’s office in Palo Alto, Calif. These voluntary trading restrictions “can make it very inconvenient” for employees who want to trade company securities, Furbush said. NEW APPROACH Under the new rule, employees can now execute trades even during black-out periods where they would otherwise be banned from doing so, as long as such trades are made under a previously prepared written plan. As a result, Furbush predicted, “within a year these types of selling plans are going to be very very common.” The plan must either specify — or provide a written formula or computer program for determining — the amount, price and date of future trades. An insider may also relinquish control over trading decisions to someone who is not privy to inside information. Thus, for example, Microsoft Corp. Chairman William H. Gates could give a written instruction to sell 1,000 shares on the first trading day of each month to fund the William and Melissa Gates Foundation. Then, even if he later learns of pending litigation that will pound the stock or a technological breakthrough that will boost it, the trade is still legal. Until now, the courts largely defined today’s insider-trading law, which developed out of the general antifraud provision of the Securities and Exchange Act of 1934. The SEC “always took the position that an insider’s knowing possession of material inside information alone” while making a trade was enough to establish its illegality, said David Levine, senior advisor to the SEC’s director of enforcement. The 2nd Circuit U.S. Court of Appeals, in its 1993 decision, United States v. Teicher, 987 F.2d 112, adopted the SEC’s “knowing possession” standard, reasoning that “[u]nlike a loaded weapon which may stand ready but unused, material information cannot lay idle in the human brain.” But then two appellate courts rejected the SEC’s stance. The 11th Circuit, in Securities and Exch. Comm’n v. Adler, 137 F.3d 1325 (1998), ruled that prosecutors had to prove “use” of the inside information in making the trade, although it agreed that “possession” created a strong inference of “use.” That same year, in United States v. Smith, 155 F.3d 1051, the 9th Circuit ditched the “possession” standard altogether, ruling that, at least in the criminal context, only “use” of inside information was forbidden. In a footnote, the 11th Circuit invited the SEC to resolve the split among the circuits by issuing a rule. The SEC did so, coming up with 10b5-1, which states that a person trades on the basis of material nonpublic information if he is “aware” of that information when making the purchase or sale. The new “awareness” standard “is a fine-tuning of the word ‘possession,’ ” said Levine. “ You have to have the information not just in pocket but also in mind,” he added. For example, he explained, a memo on the desk that the insider has not read would constitute “possession” but not “awareness.” Many lawyers who advise clients on insider trading laws welcomed the new regulation. “The rule provides helpful guidance to executives trying to manage their portfolios without getting into trouble with the SEC,” said Colleen P. Mahoney, a partner at the Washington, D.C., office of Skadden, Arps, Slate, Meagher & Flom LLP. Other securities lawyers, while applauding the SEC’s effort to define insider trading, voiced concerns with various aspects of the rule, including problems with the “awareness” standard. James Q. Walker, a partner with Richards Spears Kibbe & Orbe, contended that “to the extent the ‘awareness’ standard still looks and feels like a ‘knowing possession’ standard, the rule approaches strict liability” for insider traders. “It goes a step in the right direction,” he said, “but it doesn’t give defense counsel a whole lot of comfort.” Attorneys also worried that the SEC intends the affirmative defenses to charges of insider trading provided by the rule, such as the written trading plan, to be exclusive. If this is the case, said Allan Horwich, a partner at Chicago’s Schiff Hardin & Waite, “if you don’t fall specifically into one of these categories you may be subject to liability.” “Like any of the SEC’s safe harbors, if you follow their road map, you’re OK,” he added, “but you have to follow their road map.” Professor Nagy expressed misgivings that the affirmative defenses potentially could create a disincentive for officers and directors to release information to the market by permitting them to make trades while privy to material inside information. Prohibiting those in control of company information to trade shares before the information is public encourages them to release it, she explained. In this regard, Professor Nagy said, the new rule represented “a complete about-face” from the SEC’s traditional view. From an outside investor’s perspective, Rule 10b5-1 generated little controversy. “I don’t think the rule is as problematic for investors as some fear,” said Robert Gabele, director of insider research at First Call/Thomson Financial. He did express dismay that it does not require trading plans to be disclosed or filed with the SEC. All these issues promise to make the next couple of years interesting as the rule gets tested in the field and the courts. Walker predicted that neither the 9th nor the 11th Circuits would step back from their “use” standard, and that over time there would be a “greater divergence between the SEC rule and what’s happening in the courts.” “A couple of years down the road, the SEC will be looking at this issue again,” he said. In the meantime, “nothing has really changed” for securities defense lawyers, he said, adding, “We’ll still be making the same arguments we’ve always made.”

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