Pomerantz LLP

Executives Seeking To Avoid Securities Fraud Liability Must Plan Ahead

Attorney: Matthew L. Tuccillo
Pomerantz Monitor March/April 2016

A key element of any securities fraud claim is evidence of defendant’s scienter, or intent to defraud. One way to establish scienter is to show that a given defendant engaged in transactions (typically sales) in company securities during the alleged period of fraud. Indeed, a complaint that does not allege such transactions faces heightened scrutiny by the court on a motion to dismiss.

Executives trying to explain such transactions frequently point to the existence of a so-called Rule 10b5-1 stock trading plan, which, for example, could schedule automatic stock transactions at pre-determined intervals or at specific future times. Rule 10b5-1, enacted by the SEC in 2000, expressly states that a person’s transaction in a security is “not ‘on the basis of’ material nonpublic information” if it is demonstrated that “before becoming aware of the information, the person had…[a]dopted a written plan for trading securities.” See 17 C.F.R. 240.10b5 -1(c)(1)(i)(A)(3). Since then, the case law has strongly weighed in favor of executives who had sold company stock, even at the height of an alleged fraud, where the sales were made pursuant to such a trading plan, often ruling that stock trades made pursuant to the plan could not evidence scienter. 

However, one dogfight in which we frequently engage revolves around the circumstances and timing of a Rule 10b5-1 plan’s creation. In our experience, too often, executives chose either to adopt a new Rule 10b5-1 plan or to amend a pre-existing Rule 10b5-1 plan during the period of alleged fraud, frequently causing an increase in sales of company stock at inflated prices before the fraud gets revealed and the stock price corrected by such revelation. The executives later seek to hide behind the existence of such a plan as exonerating evidence of their lack of intent to profit from an alleged fraud, while we typically argue that the timing of its adoption or amendment negates that argument.

An important battleground on this issue has been the Second Circuit, which encompasses the U.S. federal district courts in Connecticut, Vermont, and most significantly, New York. For context, according to a recent report prepared by Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse, the Second Circuit alone accounted for 50 of the 189 (26.5%) securities class action lawsuits filed in 2015. Historically, we have relied upon a collection of lower court decisions from within the Second Circuit that discounted reliance by company insiders on Rule 10b5-1 plans adopted or amended during an alleged period of fraud. Included among them is George v. China Auto Sys., Inc., No. 11 Civ. 7533 (KBF), 2012 WL 3205062, at *9 (S.D.N.Y. Aug. 8, 2012), in which Pomerantz secured a ruling that Rule 10b5-1 trading plans entered into during the alleged period of fraud did not dispel the inference of the defendant executive’s scienter. Defendants, not surprisingly, have instead relied upon district court cases supporting the more generalized legal proposition that the existence of a Rule 10b5-1 plan undercuts the scienter inference, attempting to side-step the more nuanced factual issues surrounding the timing and circumstances of a plan’s adoption or amendment.

The Second Circuit Court of Appeals recently weighed in on this important issue, resolving it in favor of our  plaintiff side arguments in Employees’ Ret. Sys. of Gov’t of the Virgin Islands v. Blanford, 794 F.3d 297 (2d Cir. 2015).

Blanford concerned an alleged fraud regarding Green Mountain Coffee Roasters, Inc. and its Keurig brewing system, where investors were told that Green Mountain’s business was booming, with its inventory at “optimum levels” as it strained to meet high demand. In reality, it had been accumulating significant overstock of expiring and unsold product. During the alleged fraud, company insiders, including defendants Blanford (Green Mountain’s President/CEO/Director) and Rathke (its CFO/Secretary/Treasurer), sold company stock for millions of dollars in proceeds. Both Blanford and Rathke entered into new 10b5-1 trading plans just after one alleged misstatement (an earnings call), which permitted them to engage in significant sales shortly thereafter. The fraud was later revealed, causing Green Mountain’s stock price to plummet.

On these facts, the Second Circuit, citing Pomerantz’s decision in George v. China Auto Sys., among other precedent, rejected defendants’ argument that the 10b5-1 plan insulated them from an inference of scienter. Noting that Blanford and Rathke had entered into their 10b5-1 plans after an alleged misstatement (the earnings call) and after the fraudulent scheme began, the Second Circuit held: “When executives enter into a trading plan during the Class Period and the Complaint sufficiently alleges that the purpose of the plan was to take advantage of an inflated stock price, the plan provides no defense to scienter allegations.” Viewing the alleged facts holistically, the court held that defendants’ stock sales – including those made within the 10b5-1 plans – coupled with other alleged conduct (e.g., steps taken to conceal the true facts from investors), supported a strong inference of their scienter. Going forward, Blanford will be an important precedent, both in the Second Circuit and beyond, and we have already cited it to courts overseeing briefing on motions to dismiss our clients’ complaints.