Rule 10b-5 prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security, including insider trading. Intent to defraud is an element that must be alleged and proven in securities fraud cases. Sales of stock by an insider are often alleged as evidence of intent to defraud. Under a recently decided case, the U.S. Supreme Court now requires that an inference of scienter be more than merely plausible or reasonable in order for a plaintiff to meet the "strong inference" of scienter requirement under 10b-5. The inference must be cogent and at least as compelling as any opposing inference of non-fraudulent intent. 

Elam v. Neidorff, a recently decided federal district court case in Missouri, illustrates this principle. In Elam v. Neidorff, the trading program authorized sales on certain dates if the company's stock price was above $25. Shares were sold just before the announcement that the company's earnings had to be restated. Without specific allegations showing that these types of sales were inconsistent with the key officers' prior trading history in the company's common stock, sales pursuant to the automatic trading plan were insufficient to show scienter.

The interesting accounting issue related to the company's use in its financial statements of estimates of costs incurred, but not billed by Medicare. In this case, the company touted its state-of-the-art monitoring system in order to compute such estimates. The plaintiffs argued that with its state-of-the-art monitoring system, the company's estimates of these costs should always be accurate. In fact, they were inaccurate for a particular quarter and the company was compelled to substantially reduce its earnings, precipitating a sudden and large decline in the price of its stock. 

The plaintiffs were unable to dispute the mathematical rules and algorithms used by the company to create the estimates. The court held that the complaint was deficient, since the plaintiffs were unable to allege facts to show that the defendants were in possession of information that their algorithms, clinical rules or the data being entered to compute the estimates for that quarter were corrupted or inaccurate. The fact that medical costs were at the core of the company's business does not mean that the individual defendants or the company had actual knowledge that these estimated costs either historically or for that quarter were knowingly and falsely reported to the investing public. This is so even where that item is obviously a key element in determining earnings and in evaluating the value of the company's securities. 

Globas Capital Partners, L.P. v. Stone Path Group is a recent decision that analyzes the situation where a subsidiary may not have proper internal audit controls. The issue presented was whether the officers of the parent company were under a heightened duty to detect the lack of proper internal controls of its major subsidiary. The court answered the question in the negative, since there was no allegation that these officers had direct knowledge of the flaws in the internal accounting system of that subsidiary.

The moral of the story is to create an automatic trading plan for your executives and other key employees and to make sure that these persons abide by the plan. In this way, you will be protected against fraud claims if something unforeseen happens.

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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com