June 15, 2009

The SEC versus Mozilo: Insider Trading and Rule 10b5-1 Plans

For some time now, we have been waiting to see if the SEC would bring any insider trading actions involving the use of Rule 10b5-1 plans. Ever since the SEC Enforcement Staff first mentioned concerns with potential abuses of Rule 10b5-1 plans back in 2007, much has been made of how to avoid invalidating a Rule 10b5-1 defense (for comprehensive coverage of these issues, see our “Rule 10b5-1” Practice Area). Now, we have the SEC’s complaint against Countrywide’s former CEO Angelo Mozilo and others as a first of its kind SEC case questioning trades made under Rule 10b5-1 trading plans.

The SEC’s complaint in the Countrywide case alleges that Mozilo and two co-defendants misled investors about the problems that the mortgage lender faced, with contemporaneous e-mails painting a picture of significant internal concern over the company’s lending practices, while at the same time the company was portraying a rosy picture to the investment world. In this regard, SEC Enforcement Director Robert Khuzami, waxing poetic, called the situation “a tale of two companies” in the SEC’s press release announcing the action.

In the complaint, the SEC notes that Mozilo entered into four Rule 10b5-1 sales plans in late 2006, in each case while he was in possession of material non-public information about the mounting credit risk that Countrywide faced and the expected problems with the Countrywide-originated loans. With respect to his October 2006 sales plan, for instance, the SEC alleges that Mozilo established the plan one day before sending an e-mail to his co-defendants stating “we are flying blind on how these loans will perform in a stressed environment of higher unemployment, reduced values and slowing home sales.” Over the course of the next 12 months, Mozilo exercised over 5 million options and sold the underlying shares pursuant to the Rule 10b5-1 plans, resulting in proceeds of over $139 million.

The Mozilo complaint for the most part focuses on one of the most fundamental elements for a successful Rule 10b5-1 defense – that the person entering into the plan must not be in possession of material non-public information at the time of entering into, or amending, the plan. I still get the question from time to time of whether a person can enter into a plan while in possession of material non-public information so long as trading does not commence until after the information is made public, which obviously can never work.

It will probably be some time before this case makes it to trial. It remains to be seen whether the Mozilo case is just one isolated incident of allegations involving Rule 10b5-1 plans, or whether more of its type are on the way. In any event, I think that the threat of the SEC cracking down on Rule 10b5-1 plans has in all likelihood cleaned up most abuses in this area (if there were any to start with).

In this entry from the D&O Diary blog, Kevin LaCroix provides a great explanation of why it is appropriate for Bank of America to be advancing Mozilo’s defense expenses.

Academic Research on Hedging Transactions and Abnormal Returns

As Mike Melbinger recently noted in his blog, a recent academic study has highlighted a potential relationship between executives entering into prepaid variable forward contracts and a drop in their company’s stock price. (The study is discussed in this WSJ article). This research could potentially raise the SEC’s attention concerning these types of transactions, similar to the way that research on well-timed Rule 10b5-1 plans originally garnered the SEC’s attention on those plans. While it doesn’t seem that prepaid variable forwards have been as popular as they once were, they still offer an alternative for executives to diversify and monetize a portion of their stock holdings.

The Administration’s Regulatory Reform Proposals Expected This Week

In this Washington Post piece appearing today, Timothy Geithner and Lawrence Summers lay out the Administration’s plans for financial reform. The piece discusses how the Administration’s proposals will address five key problems. Among the solutions, Geithner and Summers indicate that the plan will call for “harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of ‘over the counter’ derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse.”

The WSJ also reports today that announcement of “the most sweeping reorganization of financial-market supervision since the 1930s” is expected this Wednesday. [It seems that in this phase of the financial crisis and its aftermath, Wednesday is the new Sunday. It used to be last Fall that we would wait until Sunday evening before Asian markets opened to find out what major calamity had been averted or precipitated. Now, major announcements seem to be happening on Wednesdays, which takes away some of the drama but is perhaps a good sign.]

From the WSJ report, the only agency on the chopping block is the Office of Thrift Supervision – otherwise, financial regulatory authority is expected to be reallocated so as to avoid gaps in regulation. As many have expected, the Federal Reserve will garner more power under the Administration’s proposal, overseeing the largest of financial institutions with enhanced authority.

It remains to be seen how quickly Congress will act on these proposals – healthcare seems to be taking center stage away from the financial crisis as signs of normalcy on the economic front have begun to emerge.

Deal Protection: The Latest Developments in an Economic Tsunami

We have posted the transcript from our recent webcast: “Deal Protection: The Latest Developments in an Economic Tsunami.”

– Dave Lynn