Risks and rewards of directorships at portfolio companies

Curbing illegal insider trading has always been a pillar of the SEC’s enforcement program, but never before has the agency so aggressively targeted corporate insider trading on the basis of material non-public information (MNPI). In the past three years, the SEC has filed more than 170 insider trading actions, charging nearly 400 individuals and entities. 

In response to articles appearing in the Wall Street Journal, officials in the SEC’s division of enforcement have recently indicated that the agency’s anti-insider trading program has found a new focus: investment funds’ trades in the stock of corporations with board members who are affiliated with the buying/selling funds. This new focus will greatly increase the risks associated with this relatively common practice. 

Directors affiliated with investment funds should not rush to abandon their board seats, however. By implementing policies designed to withstand this scrutiny – such as establishing rules governing when directors and affiliated funds may set up Rule 10b5-1 trading plans, limiting modification or cancellation of those plans, and developing information barriers between the director and the affiliated fund’s employees – the directors, corporations and funds involved in such trading can effectively mitigate the risk of becoming just another statistic in the SEC’s anti-insider trading program.

Corporate insiders have reduced the risk they will face illegal insider trading allegations by agreeing to trading restrictions or disclosure requirements and, especially in instances where an investment fund’s affiliate has assumed an insider position, by developing information barriers that restrict or eliminate the transmission of MNPI between individuals and their colleagues, employers and others who may seek to benefit their trading by using the insider’s MNPI. 

For example, companies may allow directors to trade in company-issued securities only after obtaining authorization from the corporation’s general counsel or audit committee chairperson. Alternatively, corporations may prohibit trading in company-issued securities at certain times – known as blackout periods – when directors and officers are most likely to be in possession of MNPI, such as the six weeks immediately prior to the corporation’s quarterly earnings announcements.

Risk mitigation via 10b5-1 plans

In 2000 the SEC promulgated Exchange Act Rule 10b5-1 to provide corporate directors and officers with a means of diversifying their holdings that is more flexible than the blackout periods or absolute trading abstentions traditionally used to prevent illicit use of MNPI. Rule 10b5-1 provides an affirmative defense to illegal insider trading allegations when a corporate director adopts a written plan, when he or she does not possess MNPI, committing the director to future trades in the corporation’s stock, no matter whether that director possesses MNPI when those trades are executed or not. 

By promulgating Rule 10b5-1, the SEC recognizes that if an insider without MNPI puts into place a plan to sell a predetermined amount of shares at a scheduled time, any sale pursuant to that plan would not be based on MNPI. This applies even if the trader comes into possession of MNPI prior to the sale because the trader would not be ‘using’ that information to trade.

Rule 10b5-1 identifies the requirements that trading plans must meet in order to assert a defense. First, to successfully use the affirmative defense, anyone entering into a written plan for trading securities must show he/she did so before becoming aware of MNPI. Second, the trading plan must either expressly specify the amount, price and date of the securities that will be traded, or provide a written formula or algorithm for determining amounts, prices and dates. 

The plan cannot permit the corporate insider to exercise subsequent influence over how, when or whether to effect purchases or sales. Third, the purchase or sale must be pursuant to the written plan. Otherwise stated, the affirmative defense is not valid if the trader alters or deviates from the trading plan or enters into a corresponding or hedging transaction or position with respect to the securities.

Although academic studies suggesting that corporate insiders’ 10b5-1 trades return abnormal profits have reportedly piqued the SEC’s interest in 10b5-1 plans, the agency’s insider trading actions typically have not involved trading pursuant to those plans. This may reflect either the SEC’s view that pursuing an insider trading investigation involving such plans is an ineffective use of resources, or the regulator’s search for an ‘example case’ involving such plans that it believes will send a message to corporate insiders. 

Pros and cons of directorships for investment funds

Investment funds regularly make significant investments in publicly traded firms and, as a result of their considerable investment, obtain the right to nominate or seat directors on corporate boards. This ability to appoint trusted associates, or fund employees, to the board of a portfolio company is of great value and provides funds with a means of protecting their investment via a seat at the table for important decisions involving corporate strategy, the hiring of executives and oversight of those executives’ management of the company’s affairs. 

Funds with affiliates on portfolio companies’ boards have the ability to align a corporation’s governance with the fund’s investment goals; use the fund’s business expertise to improve efficiency and maximize the value of the fund’s investment; gain access to MNPI about the corporation’s business; and influence when and how that information is made public. The benefits of directorships have traditionally provided unquestionable value to investment funds, but in this era of heightened scrutiny on the trading activity of corporate insiders, funds with affiliated persons serving as directors of portfolio corporations may also be subjecting themselves to significant regulatory risk.

Investment funds and affiliated people serving as directors of portfolio companies need only restrict their trading when the individual director and affiliated fund come into possession of MNPI. As corporate directors are often in receipt of MNPI, tools providing corporate insiders’ trading with a degree of protection from regulatory inquiry or liability – trading restrictions, information barriers and especially the use of Rule 10b5-1 trading plans – are critical for investment funds with affiliates on the board of portfolio firms when funds actively trade the portfolio company’s stock, as they significantly reduce the risk of insider trading liability. 

Preserving the benefits of directorship 

Historically, the advantages to an investment fund of having a representative on the board of a portfolio company have significantly outweighed the risks, in large part due to Rule 10b5-1. By creating an affirmative defense against insider trading, a properly used Rule 10b5-1 plan allowed directors and affiliated funds to reap the rewards of holding a board position while providing a way to sell stock with limited insider trading risk. Moreover, the benefit of potentially being shielded from insider trading allegations outweighed concerns that a trading plan would force an individual to sell stock at inopportune times or at unfavorable prices.

This calculus may be changing, however, as the SEC’s spotlight shifts to investment fund representatives who hold directorships of portfolio companies and the practices used by those funds to sell shares in those firms. Several recent Wall Street Journal articles appear to have amplified regulators’ and prosecutors’ interest in the use of 10b5-1 plans, particularly by corporate directors who are affiliated with investment funds. 

On April 25, 2013, the WSJ reported that a federal prosecutor ‘urged hedge fund compliance executives to be vigilant about trading by directors who also run investment funds’ and that an area ‘coming down the pipe’ involves cases in which board members ‘use 10b5-1 plans as a cover to trade out of stock positions amid bad corporate news.’ This article also questions three corporate stock trades made by hedge funds affiliated with or operated by members of the issuing corporations’ boards of directors, and quotes an SEC spokesperson as saying that use of 10b5-1 trading plans by investment funds is an ‘exotic permutation’ that was not contemplated when Rule 10b5-1 was enacted. Just five days later, the WSJ reported that federal prosecutors had launched criminal investigations into whether the three directors identified in the article had misused 10b5-1 trading plans to sell shares for affiliated funds.

But even these heightened risks can be appropriately mitigated. As long as they are properly designed with a few additional safeguards, Rule 10b5-1 plans remain effective and can withstand this increased scrutiny. Directors can strengthen the affirmative defense by implementing the following additional precautions when implementing a Rule 10b5-1 plan:

 Limit the time to adopt the plan to the issuer’s open trading period

 Limit modification or cancellation of the plan once it is in place

 Avoid multiple, overlapping plans

 Create a meaningful waiting period before directors can execute initial trades under the plan; the longer the waiting period, the less likely the SEC will assert that directors possessed insider information at the time the plan was established

 Publicly disclose new plans

 Limit the percentage of holdings subject to the plan.

Furthermore, investment funds with affiliated people serving as directors of portfolio companies should actively develop information barriers designed to prevent the fund from entering trades on the basis of MNPI unintentionally ‘tipped’ by the affiliated director. One method of promoting a robust information barrier is to nominate trusted affiliates who are not fund employees, such as a reputable business person or economist who shares the fund’s views and who can easily be isolated from fund employees trading in the corporation’s stock. It is of paramount importance for funds to design information barriers to withstand the increased scrutiny that will likely be applied to this new front in the SEC’s war against insider trading.

Every few years, the SEC increases enforcement in a high-profile area. Only time will tell whether corporate insiders’ use of Rule 10b5-1 plans will rise to the level of scrutiny the SEC has dedicated over the last decade to accounting fraud matters, market timing, options backdating and the financial crisis. As Benjamin Franklin famously quipped, ‘An ounce of prevention is worth a pound of cure.’ This is certainly true in today’s regulatory environment, where news of enforcement actions and settlements dominates the headlines and potential investors are increasingly wary of funds that have been subject to SEC investigation.

The SEC on insider trading 

On its website, www.sec.gov, the SEC explains its reasons for adopting Rule 10b5-1 to help deter insider trading:

‘The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material non-public information if a trader is ‘aware’ of the material non-public information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.

‘Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.’