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Last year provided insight into what we may see in the U.S. Securities and Exchange Commission’s enforcement agenda. A succession of active commentary from SEC Chair Gary Gensler evidenced commitment toward robust enforcement of market exposures, both new and old.
Beyond the warning stage, we witnessed prioritized action by the SEC toward legacy securities market misconduct, in the form of enforcement actions last summer charging individuals with insider trading.
Efforts to uncover carefully orchestrated insider trading are not new to the SEC’s enforcement agenda. However, a review of recent Enforcement Division action shows a commitment to forcing individual accountability for abuse and misconduct and halting unfair trading advantages in the market.
In late August 2021, the SEC filed charges alleging “shadow trading” against an employee of a company targeted for acquisition by Pfizer Inc. Allegedly, the individual bought shares of a competing company in anticipation of the effect the merger announcement would have on the competitor shares. It was perhaps a harbinger of the SEC’s commitment to cast a wide net in halting unfair trading advantages.
The shadow trading case was followed by the SEC’s pursuit of a $3 million insider trading ring related to Netflix Inc. common shares that demonstrated the strength of the SEC’s increasing analytics sophistication. “The defendants allegedly tried to evade detection by using encrypted messaging applications and paying cash kickbacks,” said Joseph Sansone, chief of the SEC’s Market Abuse Unit in a statement detailing the case. “This case reflects our continued use of sophisticated analytical tools to detect, unravel and halt pernicious insider trading schemes that involve multiple tippers, traders, and market events.”
Last month, the SEC brought charges against three individuals in an alleged multimillion-dollar insider trading scheme involving trading on information gained from a relative who sat on two boards of directors of companies involved in certain transactions. To date, the director, the source of the nonpublic information, has not been charged and is only referred to as “Insider 1” in the SEC Complaint.
Reform of 10b5-1 plans
Traditional compliance protocol to prevent insider trading has centered around a company’s institution of individual 10b5-1 plans. But, as of late, in addition to recently initiated enforcement actions, Mr. Gensler has ordered his staff to undertake reform of 10b5-1 plans, the mechanism corporate insiders use to disclose intent of and initiate trading in their company’s stock.
Rule 10b5-1 provides an affirmative defense from insider trading for corporate insiders and companies to buy and sell company stock, provided they adopt their trading plans in good faith and while not in possession of material nonpublic information.
In effect, the rule allows beneficiaries to demonstrate that a purchase or sale was not made “on the basis of” MNPI. If a 10b5-1 contract, instruction or plan is properly established, the issue is not whether the insider had MNPI at the time of the purchase or sale of the security but rather that analysis was performed at the time the instruction, contract or plan was established. One of the possible changes for Rule 10b5-1 trading plans would be the addition of a “cooling off period” intended to lessen potential abuses.
10b5-1 plans allow insiders to trade company securities without the threat of being accused of insider trading. The issues with the plans as they stand are that there can be red flags, which may allow for allegations of dishonesty, and plans can be modified or canceled without advance notice or scrutiny. If the proposed changes to 10b5-1 occur, this may not continue, as directors and officers could be subjected to making trades of their respective companies’ securities pursuant to certain timeframes and restrictions in a cooling off period where they can make a modification to the plan prior to selling shares.
On Dec. 15, 2021, the SEC voted unanimously to propose new rules in connection with Rule 10b5-1 plans. The proposals have a 45-day period from the date of publication in the Federal Register before becoming official rules. The proposed amendments, which are available on the SEC’s website, would add new conditions to the availability of the Rule 10b5-1(c)(1) affirmative defense to insider trading liability.
D&O insurance implications
The directors and officers liability insurance sector should pay close attention to this and any further modifications of Rule 10b5-1, focusing on how to react to the change of tone and determining the best compliance protocols to make sure there is defensibility should an action arise.
News of the potential changes to 10b5-1 raises concerns that the plaintiffs bar is watching and planning on alleging claims of insider trading should certain actions fall outside of compliance as a result of the changes. The plaintiffs bar is adept at modifying the way in which claims are asserted and will welcome any extra ammunition Mr. Gensler’s comments may portend. One thing that plaintiffs need to prove when filing securities class action is scienter — or knowledge as to potential wrongdoing. If directors and officers are not following the 10b5-1 compliance, shareholders can use evidence of insider sales to try and indicate that the defendants knew that they were in the wrong and acted despite this knowledge.
If the rules change — and the period in which the SEC is soliciting commentary ends in February — this will represent a paradigm shift for D&O insurance. Changes to the regulation will subsequently change the risk profile; in addition to securities class-action implications, there is a heightened settlement exposure when insider trading is part of the complaint and has legitimacy. Defense costs will rise, and the potential for insider trading accusations to bring more losses cannot be underestimated. Further, SEC Enforcement Director Gurbir Grewal has stated the intent of SEC enforcement to push for admission of wrongdoing in civil case resolution, in addition to referral of the criminal case to the U.S. Department of Justice. Such admission would likely increase settlement and resolution costs.
As we wait to see exactly how the SEC will act, the insurance industry should take a close look at companies that have created these plans to protect their directors and officers and determine how they plan to comply with any new rules and regulations. We want to empower directors and officers to engage and to avail themselves of the corporate successes to which they, as shareholders, are entitled, pursuant to a fair and transparent procedure complying with attendant rules and regulations. Yet it is important to note that all public companies are at risk here, regardless of size or industry. We need to fully understand the risks and help our clients to do the same. Collectively, it is incumbent upon us all to be aware of changes, review plans, understand the best practices being employed to mitigate regulatory risk, and take steps now to ensure strict compliance.
Deirdre Martin is senior vice president, chief underwriting officer, commercial management liability and financial institutions, for Sompo International’s U.S. insurance business. She can be reached at email@example.com. Jeremy S. Salzman is senior vice president, head of commercial management liability and financial institutions claims, for Sompo International’s U.S. insurance business. He can be reached at firstname.lastname@example.org.