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At times, the job of trading compliance officer at a publicly held company may seem as thankless as that of a chaperone at a high-school dance. People figure you’re there to spoil the fun, no matter how much you tell them it’s for their own good. A key officer wants to sell some stock. His face is a picture of innocence as he assures you that recent internal events at the company have nothing whatsoever to do with the timing of his proposed sale. He has college tuition payments to make. In any case, this is an open-window period for company stock trades — what’s the problem? His innocence turns to righteous anger as you explain that he may possess material nonpublic information about the company at this time, and that you cannot approve his transaction. The Securities and Exchange Commission’s new Rule 10b5-1 may give some relief to the harried trading compliance officer. Rule 10b5-1 provides an explicit affirmative defense against liability for transactions made by an insider with material nonpublic information, if the transactions occurred pursuant to a plan or contract that was arranged prior to the insider’s possession of the information. No more policing of individual trades, if the insider’s prearranged plan passes company muster. However, the protection afforded by Rule 10b5-1 is only as good as each insider’s own prearranged plan for trading in company securities. Before the first insider walks through the trading compliance officer’s door seeking approval of an individual plan under Rule 10b5-1, the company had better have amended its insider trading policy to accommodate such plans and to establish criteria for determining which of them are acceptable to the company. KEY FEATURES OF A RULE 10B5-1 PLAN Rule 10b5-1, which became effective with relatively little fanfare Oct. 23, clarifies that an insider may be liable for trading while knowingly in possession of material nonpublic information, regardless of whether or not the insider makes use of the information. At the same time, Rule 10b5-1 creates an explicit affirmative defense to insider-trading liability under certain circumstances, if an insider trades pursuant to a plan created prior to his or her possession of the information. To take advantage of the Rule 10b5 safe harbor, an insider alleged to have traded while in possession of material nonpublic information must show that before receiving the information — and while not in possession of any other material nonpublic information — the insider: � Made a binding contract to buy or sell the securities in the future, or � Adopted a written plan for future purchases or sales, or � Instructed a third party (for example, the trustee of a blind trust), who was unaware of the material inside information, to buy or sell for the insider’s account in the future. The contract, plan, or third-party instructions will: � Explicitly specify the securities to be purchased or sold, including number of shares, prices and/or date(s) of transactions; or � Explicitly specify a formula defining future transactions — for example, “10 percent of my current holdings in ABC common stock at the market closing price on the last day of each of ABC’s next 10 fiscal quarters;” or � If the instructions are to a third party without material inside information, they may either specify the information or formulas just described, or may merely give the third party authority to act at his or her own discretion in the future. AMEND AT YOUR PERIL The insider entering into the prearranged trading plan should not retain the right to amend the instructions or formula. Similarly, the plan should not include any hedging arrangements. Either feature would endanger the effectiveness of the plan and make it appear a mere sham, in that the insider would still have some control over the occurrence of a transaction. It could be argued in hindsight that the insider had some material nonpublic information at the time he chose to alter the prearranged transaction, and that insider knowledge influenced his choice. Admittedly, this is a conservative viewpoint — the SEC acknowledged in a footnote to the adopting release for Rule 10b5-1 that the terms of a pre-arranged trading plan could be amended if, at the time of the amendment, the insider was not then in possession of material nonpublic information. However, each alteration to the plan creates a new situation in which the insider — and the trading compliance officer — must reevaluate the materiality of any nonpublic information then possessed by the insider, and consider how the protections provided by Rule 10b5-1 to prior transactions under that plan are also weakened by the insider’s intervention and reassertion of control. KEY BENEFIT OF THE RULE 10B5-1 PLAN The beauty of a prearranged trading plan compliant with Rule 10b5-1 is that even when an insider does subsequently come into possession of key nonpublic information — information the possession of which would otherwise have blocked his ability to trade — the preplanned transactions can go forward without company scrutiny or concern. Frequently it will be the insider him- or herself who will approach his or her company with a prearranged plan for buying or selling securities. The plan may have been proposed by the insider’s broker or financial planner, who has as his or her goal facilitating easy, rapid stock trades with minimal issuer involvement. The plan may be substantially compliant with Rule 10b5-1. This does not mean, however, that the company’s interests are adequately addressed by such a plan. Yet the insider will no doubt be pressuring the company to act quickly to approve his or her plan and the future transactions it proposes. To protect the company, and indeed to enable the insider to gain the full benefits of the Rule 10b5-1 affirmative defense, the company should have already examined its insider trading policy and amended it in light of Rule 10b5-1. It will then be positioned to act rapidly to approve — or require changes prior to approval of — any Rule 10b5-1 plan presented to it by an insider. AMENDMENTS TO AN EXISTING INSIDER TRADING POLICY To be well poised to take advantage of Rule 10b5-1, a publicly traded company’s board of directors should examine its current insider trading policy. Specific acknowledgement of prearranged trading plans, contracts and instructions compliant with Rule 10b5-1 may be advisable, in particular because certain precautions traditionally found in such policies, such as trading windows, may not be necessary with respect to trades made under prearranged plans. Some companies may decide to leave their trading windows in place even with respect to Rule 10b5-1 plans, requiring that the timing of planned transactions take into account the company’s established schedule for open and closed windows. This is a very conservative approach. A middle ground might be to require that no amendments of Rule 10b5-1 plans occur during closed-window periods, as well as at times when material nonpublic information about the company is available to the insider in question. A cornerstone of any revised insider-trading policy ought to be that every prearranged trading plan, contract or instructions entered into by an insider must be presented in written form to the company’s trading compliance officer or general counsel, for approval. The incentive for the insider (apart from compliance with express company policy) is that on such approval, his or her future trades under the Rule 10b5-1 plan can go forward without the need for further approval. In other words, the burden of seeking approval for the overall plan in advance is more than offset by the freedom to proceed under the plan in the future. FEATURES TO REQUIRE IN YOUR INSIDERS’ RULE 10B5-1 PLANS Your insider-trading policy should require that, as a threshold for company approval, any Rule 10b5-1 prearranged trading plan possess the following features: � Compliance with the minimal requirements of Rule 10b5-1 as to specific identification of future transactions and/or authority of a third party to act solely at its discretion; � Insiders who are unable to amend the arrangement, or may amend only at a future point when not in possession of any material nonpublic information; in any case, amendment only on notice to, and receipt of approval by, the company or its counsel; � Written copy of the plan filed with the company’s trading compliance officer; � No transactions under the plan to occur for at least one fiscal quarter after execution, to minimize even the appearance that transactions were based on inside information; �Exceptions built into the plan that will shut down transactions in the case of lockup periods (for example, during a public offering, tender offer, or merger pursuant to the pooling rules); the burden may be on the company under the plan to give the insider notice of such events; and � Notice requirement to the company, whether by the insider or his or her broker, of each transaction under the plan so that compliance with � 16 and Rule 144 filing requirements can be monitored by the company. PUBLICITY SURROUNDING RULE 10B5-1 PLANS Once a company has amended its insider-trading plan to accommodate Rule 10b5-1 plans, the stage is set for a press release announcing the change. The benefit afforded by a blanket press release is that it probably obviates the need, at a subsequent date when a key officer enters into a Rule 10b5-1 plan of his or her own, to issue a specific press release about that event. Some practitioners nonetheless suggest specific press releases if highly visible officers enter into individual Rule 10b5-1 plans. A middle ground might be to disclose the existence of such plans on the investor relations page of the company’s web site, or in the annual proxy materials or report to shareholders. WHEN THE COMPANY INITIATES THE PLAN Although it will usually be the individual insider who initiates a request for approval of a Rule 10b5-1 plan, companies are finding it to their benefit to initiate such plans themselves under certain circumstances. For example, when a stock option plan is drawing near its expiration date, a company may wish to establish a prearranged plan for the cashless exercise of options and sale of underlying stock, by announcing the number of shares, effective dates, and so forth, that will apply. Handling this situation by means of a prearranged plan under Rule 10b5-1 means that the insiders affected will be able to exercise their options, and sell sufficient underlying shares to pay for the exercise, at set future dates prior to the plan’s expiration — even though at the future date, they may unwittingly find themselves in possession of material inside information that would otherwise have precluded such exercise and sale. (Of course, neither the company nor its insiders can have been in possession of material nonpublic information at the time the prearranged plan was first established.) Similarly, the company may wish to conduct prearranged repurchases of its own stock by insiders in the same manner. If it makes use of the Rule 10b5-1 safe harbor and irrevocably prearranges the dates, prices, amounts and other pertinent features of the transactions in advance, at a time when there is no material nonpublic information available, it can then proceed with the repurchases despite the availability of nonpublic information on the relevant future dates. SCOPE OF THE RULE’S PROTECTION It is important to bear in mind that Rule 10b5-1 provides an affirmative defense to insider-trading liability. Insider transactions purportedly relying on Rule 10b5-1 may nonetheless be questioned by the SEC; however, compliance with Rule 10b5-1 will, according to the SEC, provide a satisfactory answer to questions raised. Similarly, the press may still question the motives of high-profile insiders who trade stocks at unfortunate moments, even though such insiders may have the full protection of Rule 10b5-1 as an affirmative defense. At least the new rule makes such a defense explicitly available, although it may not ward off a public relations problem. Particularly in the case of shareholder class action suits, however, where trading by insiders may be used to support the plaintiffs’ claim of scienter, careful compliance by insiders with Rule 10b5-1 is likely to be a powerful weapon in the hands of the defense. Thus, it is in the interest of public companies to understand and implement Rule 10b5-1 now as one key element of an effective insider-trading policy. Eileen Smith Ewing is a partner in Kirkpatrick & Lockhart LLP’s Boston office, where she chairs its Growth Companies Practice Group.

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