Image by Gerd Altmann from Pixabay

Apparently, I wasn’t the only one who thought it was odd to enforce what was essentially an insider trading matter as an internal accounting controls matter.  Commissioners Peirce and Roisman agreed in a November 13, 2020  “statement” that can be found here.

Let’s assume that you are an executive of a company; that you have material non-public information about the company that will, when announced, cause the company’s stock to increase in value; that the company has a policy that prohibits trading when in possession of MNPI; and that you make an open market purchase of the company’s stock before the information is made publicly available.  What are the odds that you will be charged with fraud or insider trading?

Let’s assume a similar but slightly different set of facts:  The company has material, non-public information that will, when announced, cause the company’s stock to increase in value; the company has a policy that prohibits trading when in possession of MNPI; before this information is made publicly available, the company enters into a so-called Rule 10b5-1 plan to facilitate a stock buyback program; and the company then proceeds to buy shares of its stock under the Rule 10b5-1 plan.  What are the odds that the company will be charged with fraud or insider trading?

If you answered both questions the same way, you may be wrong.  In a recent enforcement action involving the second fact pattern above, the SEC opted not to charge the company or its executives with fraud or insider trading.  Rather, the problem, according to the SEC, was that the company had “insufficient” internal accounting controls.  Without going into too many details, the SEC’s theory goes something like this:

  • The company’s board of directors authorized the expenditure of $2 billion for share repurchases.
  • The authorization required the company “to comply with a policy that prohibited the company from repurchasing stock while it was in possession of material non-public information.”
  • The Rule 10b5-1 plan was approved by the company’s legal department, executed, and implemented, all while the company was in possession of material, non-public information. A total of 2.6 million shares were purchased for a total slightly in excess of $252 million.

The SEC’s enforcement report suggests that the company was aware that entering into and executing a Rule 10b5-1 plan would be problematic if the company were in possession of MNPI.  For example, its legal department appears to have blessed proceeding with the plan.  However, according to the SEC, the department’s guidance was “based on a deficient understanding of all relevant facts and circumstances” and thus wrongly concluded that ongoing acquisition discussions “did not constitute material non-public information.”  A key factoid seems to have been that the company’s chairman and CEO “directed the company’s [CFO]…to repurchase…shares” despite that fact that he was scheduled to meet with his counterpart at the acquiror two days later.  As a result, the SEC concluded that the legal department’s

“lack of understanding was the result of… insufficient internal accounting controls. [The company] used an abbreviated and informal process to evaluate the materiality of the acquisition discussions that did not allow for a proper analysis of the probability that [it] would be acquired. [Its] informal process did not require conferring with persons reasonably likely to have potentially material information regarding significant corporate developments prior to approval of share repurchases. As a result, for example, despite [the] CEO’s leadership role at the company and the fact that he was the primary negotiator with [the acquiror], no one involved… discussed with him the prospects that [the company]… would agree to a deal. Because they did not do so, the company failed to appreciate that the probability of [the] acquisition… was sufficiently high at that time as to be material to investors. In short, [the company] did not have internal accounting controls that provided reasonable assurance that its buyback would be executed in accordance with its [b]oard’s authorization.”

It is not clear why the SEC opted to avoid more “simple” charges of insider trading, fraud, etc.  Perhaps it reflects that there were multiple parties and too many disconnects among the parties.  And perhaps the SEC just felt that it was an opportunity – too good to ignore – to bring home that fact that a perfunctory approach to enforcing insider trading policies is not enough.

On the other hand, it seems odd that the whole case turned on the fact that the board’s authorization referred to the company’s insider trading policy.  I’ve drafted resolutions authorizing buyback programs that didn’t refer to compliance with insider trading policies, and frankly I don’t think such a reference is needed, any more than it’s necessary to say that permissible actions need to be executed in accordance with all relevant company policies, applicable law, etc.

All that being said, however, the company was required to pay a $20 million fine and enter into a customary cease-and-desist order.  So the moral of the story may be that where an SEC enforcement action is concerned, there seem to be alternate routes to get to the destination.