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Rule 10b5-1


Insider trading laws broadly prohibit trading on the basis of material, nonpublic information. A safe harbor is provided by new Securities and Exchange Commission Rule 10b5-1: Trading "on the Basis of" Material Nonpublic Information, which was adopted August 15, 2000.

The full text is available at

http://www.sec.gov/rules/final/33-7881.htm

Rule 10b5-1 provides that, for purposes of Insider Trading, a person trades on the basis of material nonpublic information if a trader is aware of the material nonpublic information when making the purchase or sale. The rule establishes certain exceptions to liability. These exceptions permit a person to trade in specified circumstances where it is clear that the information is not a factor in the decision to trade, such as when trades are made pursuant to a pre-existing plan. Since Rule 10b5-1 specifically identifies what is allowed, it provides Insider guidance about how they can safely trade in their companies' securities. This rule may prove particularly important to stock option holders seeking to implement hedging strategies that require periodic portfolio adjustments.

New Rule 10b5-1 prohibits trading on the basis of material nonpublic information, and further specifies that a trade is "on the basis of" inside information if the trader was "aware" of the information when he made the trade. In adopting this Rule, the SEC explained that "the awareness standard reflects the common sense notion that a trader who is aware of inside information when making a trading decision inevitably makes use of the information."

The SEC also adopted rules, in the form of affirmative defenses that specify how individuals trade in their own holdings of the company's securities and avoid legal jeopardy. The individual or entity may:

  • enter into a binding contract to purchase or sell the security;
  • provide instructions to another person to execute the trade for the instructing person's account; or,
  • adopt a written plan for trading securities.

To be eligible for the affirmative defense, the person seeking to assert the defense must be able to demonstrate that:

  • The contract, instructions, or plan was established before the individual became aware of the material, nonpublic information.
  • Either a written formula or algorithm determines the amount, prices or dates of the trade; or any person who influenced the trades was not aware of the material nonpublic information when influencing the trades.
  • The trade was made pursuant to the contract, instructions, or plan.

Note: Federal courts of appeals have disagreed about what establishes liability for prohibited insider trading. Under a strict standard, trades are improper if an insider merely possesses nonpublic information at the time of the trade. An alternative standard further required that the insider used the information and made the trade because of the information.


Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 863-0048
huddart@psu.edu
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http://personal.psu.edu/sjh11/OptionGlossary/Rule10b51.shtml
was last updated on Tue, Aug 21, 2018.
Today is Thu, Sep 19, 2019.

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