Executive Stock Sales and Securities Class Actions

by Boris Feldman


High technology companies have a different way of doing business. The culture of a technology firm bears little resemblance to that of a more traditional corporation. One of the principal differences is in their respective approaches to executive compensation. High tech companies generally have eschewed the high salaries common in larger companies, in favor of compensation packages tilted heavily toward stock options.

Employee stock options are the fuel for the engine that is Silicon Valley. Options attract precisely the types of entrepreneurs that these young, risky companies need. Options have incentivized many employees to devote themselves single-mindedly to their firm, in hopes of hitting the jackpot with a successful product. In addition, young companies are rarely flush with cash. Option-based compensation enables them to compete for talent against companies able to offer much larger salaries and bonuses.

From a societal standpoint, this option-oriented approach to compensation provides a direct vehicle for aligning the officers' interests with those of the shareholders. The employee's incentive is to maximize shareholder wealth: if the stock goes up for the shareholders, then the employee directly benefits. If the company does poorly, the employee suffers along with the owners.

The concept of incentive options is under attack. The accounting establishment, more comfortable with traditional corporations, has sought (thus far, unsuccessfully) to impose an extreme financial hit on companies that compensate using options. Ironically, incentive options have also been attacked by lawyers who purport to represent shareholders in high-tech companies. The plaintiffs' securities bar thrives on suing executives for exercising their stock options. This article suggests one possible way of immunizing executives from such attacks.

How You Get Sued

The phenomenon of securities fraud class actions is well-known. A company experiences a disappointing quarter. Its stock price falls. It gets sued. The plaintiffs name as defendants the company, together with all of its officers who sold stock in the last several quarters.

In most shareholder class actions, the plaintiffs begin the case with three things: an announcement of bad news that surprised the market; a huge stock decline; and sales of stock by company insiders during the months before the problems surfaced. Without all three, it is unlikely that a suit will be brought (although, with a large enough stock drop, the plaintiffs may sue despite the absence of insider sales).

It is virtually certain that plaintiffs will be able to find stock sales by insiders in a technology company. Because of the incentive option model of compensation, a substantial portion of the executives' pay will be in the form of options. To realize the fruits of their labors, most executives will periodically exercise some of the options and sell the stock that they receive from the exercise.

The impact of these stock sales on a securities fraud suit is potent. On the simplest level, plaintiffs can whip up the jury's resentment against rich folks, ranting about how many millions the executives made. At every turn in the case, plaintiffs offer up the stock sales as proof of the alleged fraud: they use it to demonstrate motive and intent; they argue that the executives were bailing out of the stock because they knew that the downturn was approaching. Even some judges have said that, in their mind, the difference between a "clean" and a "dirty" case is whether the insiders were selling their option stock.

Current Defenses

Defendants in shareholder suits try to explain their trades in several ways, with varying degrees of success. Most public companies in the technology sector utilize "trading windows": beginning late in the quarter (typically, at the start of the last month), executives may not trade in the company's stock until after the quarterly earnings release is issued (typically, in the month after the quarter ends). Thus, the window is closed during the most sensitive period every quarter, when management begins to know whether or not the target will be reached. Companies with trading windows also may close them if sensitive acquisition discussions are under way or pending important announcements.

Trading windows are a good idea, but they have been of limited use in defending against shareholder class actions. Plaintiffs in those cases routinely allege that insiders saw the problems coming months, or even quarters, before the disappointing results. The fact that no one traded in the last few weeks of the quarter thus may not refute the plaintiffs' claim. Indeed, because executives tend to trade immediately upon the opening of the window post-earnings release, their trades are often clustered together during a few days, enabling plaintiffs to shout "conspiracy!"

The other principal defense is to show that the trades in question were not unusual, but reflected a long-term pattern of divesting options in the company. The courts have acknowledged the validity of this defense. The problem is twofold. First, the "pattern" defense may not be conclusive; plaintiffs will argue that, notwithstanding the pattern, the most recent sales were improper because they were based on inside information. Second, the pattern is rarely as consistent as a defense lawyer would like (or as the client recalls in the initial interview). When the actual trading records are reviewed, they often reflect such large variations that one cannot conclusively demonstrate that the challenged trades were just part of the pattern.

Thus, as things stand now, an executive who plays according to the rules incurs substantial risk. If she decides to exercise her options and sell the stock, in reward for her hard work for the company, she dramatically increases the likelihood of being sued for securities fraud if the company encounters a downturn during the next year.

The "Blind Trust" Approach

The following approach may offer a way out of this conundrum. The executive designates someone to act as her agent with respect to transactions in her company's stock (for example, a stock broker or trust officer). The designee is given legal power to sell the executive's stock, pursuant to a written model specified by the executive in advance. For example, the executive might direct the designee to sell 10,000 shares every quarter, so long as the stock was trading within 20 percent of its 52-week average. Alternatively, the executive might instruct the designee to sell enough stock every quarter to provide net proceeds of $250,000. The specific instructions do not matter. In effect, the executive can take whatever model she normally follows in deciding on her "pattern," and reduce it to writing for the designee.

The executive and the designee would agree that they would not discuss the company in any respect; that the executive would not suggest any trades, directly or indirectly, to the designee, apart from the written instructions; and that the instructions could only be modified in writing, with a copy to the company's general counsel.

Now, assume that this process has been in effect for several quarters, when the executive learns that her company has a substantial risk of missing the quarter. The company decides not to put out a press release — either because it has not given any guidance as to the quarter (and therefore is under no duty to predict the revenue downturn) or because the risk is too uncertain and the company may still hit its numbers. In the normal situation, the company would close its trading window: that is, it would inform its executives that they could not trade in the stock until the quarter was over and the results were announced.

In the model posited here, however, the executive would not need to direct her designee to suspend trading. To the contrary, the executive would be barred by the agreement from communicating with her designee about the company. Assume that with no knowledge of the potential downturn the designee sells stock on behalf of the executive. It is my contention that this sale would not be insider trading and should be inadmissible in a securities fraud suit based on a subsequent stock drop. With respect to the designee, he has not traded on inside information: he has no idea how the company's quarter is going. With respect to the executive, she knows about the risk to the quarter, but has not made any trading decision based on that knowledge; rather, she specified a model to be followed well in advance of the particular challenges in that quarter. In other words, this is not a trade based on undisclosed adverse information: it is based on a prior plan unrelated to that information.

Some caveats about this approach. First, get legal advice before you do this. There are a variety of issues regarding structuring of the delegation or trust, Rule 144, Section 16 limitations on short-swing profits, tax implications, etc. The executive needs to decide whether to disclose her adoption of the blind-trust approach and whether to reflect it in Form 4 reports of stock transactions. Our recent experience with a high-tech executive indicates that all these issues can be resolved, but you do need to work through them with your counsel.

Second, if you decide to pursue the blind-trust approach, you must implement it scrupulously. There can be no cheating. The executive and her designee will be subjected to vigorous discovery in connection with their trading if the stock falls. Any indication that they violated the rules of the agreement i.e., that the executive tipped off the designee to the fact that the quarter was dicey could call into question the credibility of the entire defense.

Third, the plan is subject to greater vulnerability whenever the executive changes her instructions going forward for it is at that time that her knowledge about the company matters. For example, assume that the prior instruction was for the designee to sell 10,000 shares per quarter. Following the completion of a quarter, the executive decides to change the instructions, upping the amount to 50,000 shares per quarter. If the stock hits the skids that quarter, the executive will obviously be challenged to show that she did not see the downturn coming when she increased the sales model. One possibility might be to provide that changes to the trading model will only take effect one or two quarters in the future.

Finally, the plan does not guarantee that the executive will not be sued. There are no precedents directly on point. Ironically, the first few executives who implement this approach may become more attractive targets, as plaintiffs look for test cases to attack this approach to executive stock sales.

Many executives will find this proposal unappealing precisely because it divests them of day-to-day control over their principal asset. Even though they could incorporate their own trading model into the instructions to their designee, they will conclude that the need to remain in control over their own financial affairs is worth the risk of being named in a shareholder class action. I suspect that the first executives who experiment with this approach will be ones who have already had the pleasure of seeing themselves accused of insider trading in a suit by disgruntled shareholders. For them, the blind-trust approach may provide a way of realizing the fruits of one's labors for the company, while minimizing the risk of welcoming a process-server into one's home.

Boris Feldman is a Member of Wilson, Sonsini, Goodrich & Rosati. He specializes in securities litigation.