A newly enacted Securities and Exchange Commission (SEC) rule makes it possible for executives, directors and other insiders of publicly-traded companies to trade in company stock while in possession of material non-public company information or “inside information,” provided, that the trader does not use the information.

The new rule - for those who trade within its terms — means that insiders can structure securities trades, such as stock option sales, in advance with the comfort that they won’t be required to forego selling if they become aware of inside information.

This will help executives who receive stock compensation, because the compensation is only meaningful when it can be converted from securities into dollars through a trade in the market. An insider can’t buy cars or houses, or finance the kids’ college tuition and braces using the paper gains shown in an option plan statement.

Likewise, an executive whose personal net worth consists primarily of company stock may decide to sell shares to diversify portfolio holdings, not from lack of confidence in the company but as a matter of simple fiscal prudence.

The new SEC rule applies to insider securities trading, both in open market trades and exercises of compensatory stock options. Companies and their legal advisors should be aware of the rule in reviewing corporate policies on trading by insiders.

An Extension of Rule 10(b)(5)

The new rule is an extension of the SEC’s basic anti-fraud rule, Rule 10(b) (5), which prohibits any purchaser or seller of a security from omitting or misrepresenting a material fact about the security. For more than 30 years, courts and the SEC have held that a company insider who buys or sells the company’s securities through the use of inside information has violated Rule 10(b) (5) by omitting a material fact

New Rule 10(b) (5-1) states that a person who trades “on the basis of” material non-public information has violated Rule 10(b) (5). Under Rule 10(b) (5-1), a person has traded on the basis of such information if the person was aware of the information at the time of the trade.

Material non-public information can also originate outside the company, such as knowing in advance that the “Wall Street Journal” will print an article that will affect the stock price, or that the FDA has approved a company’s new drug.

However, if a person who possesses inside information has established a contract or written trading plan before becoming aware of the inside information, sales under a contract or plan will not violate Rule 10(b) (5-1).

This “safe harbor” for trades does not apply if the contract or plan was created in an attempt to evade Rule 10(b) (5-1).

The safe harbor means that insiders could trade in the market - for example, exercising stock options and selling the shares - even if they possess inside information, so long as the trading is pre-arranged.

For example, an insider might arrange to sell shares at regular calendar intervals, or at times that the stock hits a pre-arranged target price.

To use the safe harbor, however, an insider must make a bona-fide pre-arrangement. Rule 10(b) (5-1) would not protect an insider who tried to abuse the rule by habitually setting up a sale in advance of the company’s earnings announcement, then calling off the sale if the insider thought the news would drive the stock price up.

Possession, Not Use, Standard

While the insider’s obligation regarding inside information is sometimes described as being a duty to “disclose or abstain” (disclose the information or abstain from trading), in practice, an individual insider rarely has sole control over whether a company discloses significant, corporate developments. The insider has an obligation to shareholders to disclose inside information before using it to trade and also has an obligation to the corporation to maintain the confidence of information until the corporation decides to disclose it. This means that the “disclose or abstain” duty requires the insider to abstain from trading using material information prior to the company’s release of the information.

Rule 10(b) (5-1) remedies a division in the courts on whether the “disclose or abstain” duty is triggered by an insider’s mere “knowing possession” of inside information or by an insider’s use of inside information. The rule codifies the SEC position that “knowing possession” alone will trigger the duty. The new rule supersedes case law in the 9th and 11th Circuits which said that a disclose/abstain duty does not automatically exist if an insider possesses, but is not expressly found to use, inside information at the time of a trade.

The 11th Circuit case illustrates the need for a single, clear rule. A former Comptronix executive called his friend, a member of the Cornptronix board of directors, at 7:53 a.m. the day after a board meeting.

The two men had been friends and business acquaintances for more than 30 years. They spoke for 72 seconds. The board had learned the previous day that the CEO, the president and the treasurer were accused of making $4 million of false accounting entries in Comptronix’s books.

At 7:55 a.m. the former executive called his wife. By 8:07 a.m. she had called their broker. They sold 150,000 Comptronix shares before news of the problem broke, avoiding about $2.3 million of losses.

While the seller was no longer a Comptronix insider, it looked like he had been tipped by an insider about the bad news. In such cases, the “tippee” has the same duty not to use the inside information as the “tipper” insider.

The seller told the court that he had been planning to sell his Comptronix stock anyway and the timing was coincidental. The lower court held that the seller would be liable simply on the basis of his possession of inside information at the time of trading. The appeals court reversed, stating that the seller was entitled to a new proceeding for a determination whether he had “used” inside information to make the sale.

As it noted in the release adopting Rule 10(b) (5-1), the SEC’s preference for the “possession” standard over the “use” standard stems from “the common sense notion that a trader who is aware of inside information when making a trading decision inevitably makes use of the information.”

Legal Trading By Company Insiders

Publicly traded companies should review their policies regarding trades by insiders in light of the new rule. Typical trading policies include a prohibition on insiders’ trading for several weeks before the end of each fiscal quarter and until a day or two after earnings have been announced; clearing all trades with senior management in advance; and a prohibition on trades when major announcements are pending.

A company’s goal in setting insider trading policies is to limit the likelihood that the insider’s trades can be second-guessed as having been made on the basis of inside information. Trades by insiders are often cited in class action securities lawsuits as evidence that management knew in advance that a stock was going to tumble in value.

In the past, the result of such company policies was that the insiders were locked out of market for about 6 weeks each quarter, before and after the end of the quarter - in effect, about half the year. Depending on whether the market was up or down during the times the insider was permitted to trade, these limits could be particularly trying, for insiders who received option-based compensation.

Companies should continue to maintain policies governing trades by corporate insiders and should limit trading by insiders, with an exception for pre-arranged market trades under Rule 10(b) (5-1) that have been reviewed and approved by management. Companies should also continue to require pre-clearing trades with senior management. This permits senior management to know what its executives are doing with stock and to be prepared in the event the market reacts to the insider stock trades.

Insiders who trade in their own company’s stock need to be mindful of other legal restrictions beyond the issue of trading on inside information. Section 16 of the Securities Exchange Act of 1934 prohibits insiders from taking short-swing trading profits, which occur when an insider buys and sells (or sells and buys) within any 6 month period.