Quick Answer
A purchase or sale is on the basis of material nonpublic information if the person was aware of it when trading, subject to the rule's affirmative defenses. The main defense requires a binding contract, instruction or written plan adopted before awareness, plus good faith, a cooling-off period and the other listed conditions.
The trading plan affirmative defense rule does not define insider trading. It defines what "on the basis of" means, and it sets out the arrangements that let a person trade anyway. Insider trading generally is covered in the unit on identifying and avoiding prohibited activities.
What Does "On the Basis Of" Mean?
The manipulative or deceptive devices the antifraud statute and the general antifraud rule prohibit include, among other things, the purchase or sale of a security of any issuer on the basis of material nonpublic information (MNPI) about that security or issuer.
The trade must also be in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively to the issuer of that security, to the shareholders of that issuer, or to any other person who is the source of the MNPI.
Subject to the affirmative defenses, a purchase or sale is on the basis of MNPI if the person making the purchase or sale was aware of the MNPI when the person made the purchase or sale.
Exam Tip: Gotchas
- The test is awareness, not use. The rule asks whether the person was aware of the information when trading, so a claim that the information played no part in the decision is not the defense.
- The duty can run to the source rather than to the issuer. A duty owed directly, indirectly or derivatively to any other person who is the source of the information is enough.
- The list of devices is open. The rule says the prohibited devices "include, among other things" trading on this basis.
What Must the Arrangement Itself Contain?
The defense begins with any one of three things the person must have done before becoming aware of the information: entered into a binding contract to purchase or sell the security, instructed another person to purchase or sell the security for the instructing person's account, or adopted a written plan for trading securities.
That contract, instruction or plan must then satisfy one of three alternatives:
- It specified the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold.
- It included a written formula or algorithm, or computer program, for determining that amount, price and date.
- It did not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales, provided in addition that any other person who, pursuant to the arrangement, did exercise such influence must not have been aware of the MNPI when doing so.
The purchase or sale that occurred must have been pursuant to the arrangement. A trade is not pursuant to it if, among other things, the person altered or deviated from the arrangement, whether by changing the amount, price, or timing, or entered into or altered a corresponding or hedging transaction or position with respect to those securities.
The rule defines the three specified terms:
| Term | Meaning |
|---|---|
| Amount | Either a specified number of shares or other securities, or a specified dollar value of securities |
| Price | The market price on a particular date, or a limit price, or a particular dollar price |
| Date | For a market order, the specific day of the year on which the order is to be executed, or as soon thereafter as is practicable under ordinary principles of best execution. For a limit order, a day of the year on which the limit order is in force |
Any modification or change to the amount, price, or timing of the purchase or sale underlying the arrangement is a termination of that arrangement and the adoption of a new one.
A plan modification such as the substitution or removal of a broker executing trades under the arrangement, where it changes the price or date on which purchases or sales are to be executed, is likewise a termination and a new adoption.
Exam Tip: Gotchas
- A hedge defeats the defense as surely as an amendment does. Entering into or altering a corresponding or hedging transaction means the trade was not pursuant to the arrangement.
- A modification is a termination, so the cooling-off clock restarts. Changing the amount, price or timing adopts a new arrangement rather than amending the old one.
- Not every broker change is a modification. Where a person other than the issuer runs one plan through several brokers, substituting a broker is not a modification as long as the instructions for both brokers are identical as to price, date and amount.
Which Additional Conditions Must Be Met?
Five lettered conditions sit on top of the arrangement itself.
Good faith. The contract, instruction or plan must have been given or entered into in good faith and not as part of a plan or scheme to evade the rule's prohibitions, and the person who entered into it has acted in good faith with respect to it. Good faith is required at entry and continuing.
Cooling-off period. No purchases or sales occur until the applicable cooling-off period expires, as set out under How Long Are the Cooling-Off Periods below.
Representation by a director or officer. Where the person who entered into a written plan is a director or officer of the issuer, that individual must have included a representation in the plan certifying that, on the date of adoption, the individual is not aware of any MNPI about the security or issuer, and is adopting the plan in good faith and not as part of a plan or scheme to evade the prohibitions.
No overlapping arrangements. The person, other than the issuer, must have no outstanding qualifying arrangement, and must not subsequently enter into any additional one, for purchases or sales of the issuer's securities on the open market. Three exceptions follow:
- A series of separate contracts with different broker-dealers or other agents acting for the person may be treated as a single plan, provided the individual constituent contracts, taken together as a whole, meet all of the applicable conditions of and remain collectively subject to the rule.
- That includes the rule that a modification of any individual contract acts as a modification of the whole arrangement.
- The substitution of one broker-dealer or other agent for another executing trades is not a modification, so long as the purchase or sales instructions applicable to the substitute and substituted broker are identical with respect to the prices, dates and amount of securities to be purchased or sold.
- The person may have one later-commencing arrangement for open-market purchases or sales of any of the issuer's securities, under which trading is not authorized to begin until after all trades under the earlier-commencing arrangement are completed or expired without execution.
- That allowance is unavailable if the first trade under the later arrangement is scheduled during the effective cooling-off period, meaning the cooling-off period that would apply to the later arrangement if its adoption date were deemed to be the earlier arrangement's termination date.
- An arrangement providing for an eligible sell-to-cover transaction is not considered an outstanding or additional arrangement, and is not subject to this limit.
- An arrangement provides for one where it authorizes an agent to sell only such securities as are necessary to satisfy tax withholding obligations arising exclusively from the vesting of a compensatory award, such as restricted stock or stock appreciation rights, and the insider does not otherwise exercise control over the timing of those sales.
No repeated single-trade arrangements. For a person other than the issuer, where the arrangement does not provide for an eligible sell-to-cover transaction and is designed to effect the open-market purchase or sale of the total amount of securities as a single transaction, the person must not have adopted, during the prior 12-month period, another arrangement that was designed to effect the open-market purchase or sale of all the securities it covered in a single transaction and would otherwise qualify for the affirmative defense.
Exam Tip: Gotchas
- The overlapping-arrangement and single-trade limits are both written "other than the issuer". They constrain individuals and other non-issuer persons, not the issuer itself.
- The representation condition attaches to a written plan. It is required where the director or officer entered into a plan of that kind, not to every contract or instruction.
- The multi-broker allowance is conditional on identical instructions. Prices, dates and amounts must match between the substitute and substituted broker for the swap to escape being a modification.
How Long Are the Cooling-Off Periods?
| Who adopted the arrangement | Cooling-off period |
|---|---|
| A director or officer of the issuer | No purchases or sales until the later of: 90 days after the adoption of the contract, instruction or plan; or two business days following the disclosure of the issuer's financial results in its quarterly or annual report for the completed fiscal quarter in which the plan was adopted, or, for a foreign private issuer, in the report that discloses those results. In any event, this required cooling-off period is subject to a maximum of 120 days after adoption |
| A person who is not the issuer and not a director or officer | No purchases or sales until the expiration of a cooling-off period that is 30 days after the adoption of the contract, instruction or plan |
The table has no row for the issuer, and that is the point: the cooling-off condition names only those two categories of person.
Exam Tip: Gotchas
- The director and officer period is a "later of" capped by a maximum. It runs to the later of 90 days or two business days after results disclosure, and stops at 120 days after adoption whichever way that falls.
- The 120-day cap can shorten the wait, never lengthen it. Where results are disclosed late, the cap releases the arrangement at 120 days.
What Defense Does an Entity Have?
A person other than a natural person may also demonstrate that a purchase or sale is not on the basis of MNPI by demonstrating both of the following:
- The individual making the investment decision on the entity's behalf to purchase or sell the securities was not aware of the information.
- The entity had implemented reasonable policies and procedures, taking into consideration the nature of its business, to ensure that individuals making investment decisions would not violate the laws prohibiting trading on the basis of MNPI.
Those policies and procedures may include those that restrict purchases, sales and causing purchases or sales of any security as to which the entity has MNPI, or those that prevent such individuals from becoming aware of the information. The rule opens that list, so neither approach is required by name.
Exam Tip: Gotchas
- The entity defense has two halves and needs both. An unaware decision-maker is not enough without reasonable policies and procedures, and the reverse is equally true.
What Should You Check on Exam Day?
- Ask whether the person was aware of the information when trading; awareness, not use, is the test.
- Confirm the arrangement was entered into before awareness and meets one of the three specification alternatives.
- Treat any change to amount, price or timing as a termination and a new adoption, and restart the cooling-off clock.
- For a director or officer, apply the later of 90 days or two business days after results, capped at 120 days; for others, 30 days.
- On an entity, look for both an unaware decision-maker and reasonable policies and procedures.