At an open meeting yesterday, the SEC voted to adopt new rules regarding Rule 10b5-1 plans. The vote was unanimous—albeit somewhat grudgingly in one case. Still, the notion of unanimity on an important Corp Fin regulation has seemed like something of a pipe dream in the last several years. Commissioner Mark Uyeda was even complimentary of the process employed for this rulemaking—and he is typically quite critical of the process (see this PubCo post)—noting that the process employed this time facilitated the development of more responsive final rules. Did I detect a note of relief in the Chair’s voice? Perhaps the unanimity was in part the result of concerns long expressed about potential abuse of Rule 10b5-1 plans—from studies reported in media to letters from Senators to probes conducted by the SEC and DOJ (see this PubCo post, this PubCo post and this PubCo post).  These concerns have been percolating for many years, and the adoption of rules adding new conditions to the use of the Rule 10b5-1 affirmative defense and new disclosure requirements for 10b5-1 plans has long been anticipated. After all, these plans were one of the first rulemaking targets that SEC Chair Gary Gensler identified after he was sworn in as Chair: 10b5-1 plans, he said last year, “have led to real cracks in our insider trading regime” and called for a proposal to “freshen up” these rules. (See this PubCo post.)  The final amendments add new conditions to the availability of the Rule 10b5-1(c) affirmative defense, including cooling-off periods for directors, officers, and persons other than issuers, and create new disclosure requirements. According to Gensler,

“[a]bout 20 years ago, the SEC established Exchange Act Rule 10b5-1. This rule provided affirmative defenses for corporate insiders and companies to buy and sell company stock as long as they adopted their trading plans in good faith—before becoming aware of material nonpublic information. Over the past two decades, though, we’ve heard from courts, commenters, and members of Congress that insiders have sought to benefit from the rule’s liability protections while trading securities opportunistically on the basis of material nonpublic information. I believe today’s amendments will help fill those potential gaps….These issues speak to the confidence that investors have in the markets. Anytime we can increase investor confidence in the markets, that’s a good thing. It helps investors decide where to put their money. It lowers the cost of capital for businesses seeking to raise capital, grow, and innovate, and thus facilitates capital formation.”

Here is the final rule, the press release and the fact sheet. I plan to publish an update to this post with more detail from the adopting release about the proposed rule at a later time, so stay tuned. (At the meeting, the SEC also considered a slew of proposals to overhaul the market, not covered here.)

Background of the rule

Corporate executives, directors and other insiders are constantly exposed to material non-public information, making it sometimes difficult for them to sell company shares without the risk of insider trading, or at least claims of insider trading. To address this issue, in 2000, Congress developed the Rule 10b5-1 affirmative defense. In general, Rule 10b5-1 allows a person, when acting in good faith and not aware of MNPI, to establish a formal trading contract, instruction or plan that specifies pre-established dates or formulas or other mechanisms—that are not subject to the person’s further influence—for determining when the person can sell shares, without the risk of insider trading. According to the SEC, people are “aware” of MNPI “if they know, consciously avoid knowing, or are reckless in not knowing that the information is material and nonpublic.” To be effective, the contract, instruction or plan must also conform to the specific requirements set forth in the Rule.  In effect, the Rule provides an affirmative defense designed to demonstrate that a purchase or sale was not made “on the basis of” MNPI.  If a 10b5-1 contract, instruction or plan is properly established, the issue is not whether the person had MNPI at the time of the purchase or sale of the security; rather, that analysis is performed at the time the instruction, contract or plan is established.

After the plan has been established, under current rules, there is no requirement for a cooling-off period—that is, the plan can provide for immediate trades. In addition, the person can modify it, so long as he or she is not aware of MNPI at the time of the modification, and can terminate it at any time—even if the insider is in possession of MNPI at the time. Why is that? Because the termination (and related cancellation of any planned trades) is not “in connection with the purchase or sale of any security.” Under existing rules, a person can adopt multiple plans that provide for trades, and there is no prohibition on overlapping plans. Although there are requirements that insiders report transactions on Forms 4 and 144, there is no independent public reporting requirement for 10b5-1 plans (other than the requirement on Form 144 to provide the date of plan adoption if the sale was under a 10b5-1 plan).  However, some insiders do provide that information voluntarily.

The perceived wide berth the Rule gives insiders to conduct transactions under these plans, together with the absence of public information requirements, has long fueled controversy about Rule 10b5-1 plans. Back in 2007, as reported in the Washington Post, the SEC Enforcement Chief worried that “executives are taking advantage of a legal safe harbor to sell their stock and profit before their companies report bad news….[A]cademic studies suggest that the rule may be a cover for improper activity….If executives are in fact trading on inside information and using a plan for cover, they should expect the ‘safe harbor’ to provide no defense.’” (See this Cooley News Brief.)  A few years later, a study conducted by the WSJ seemed to indicate favorable results from trading by insiders under 10b5-1 plans that appeared to be more than serendipitous. The article identified a number of problems with 10b5-1 plans, including the absence of public disclosure about the plan or changes to it and the absence of rules about how long the plans must be in place before trading under the plans can begin. (See this Cooley News Brief.) These have now become familiar themes.

Recommendations for addressing potential problems with 10b5-1 plans were also the subject of a rulemaking petition from the Council of Institutional Investors in 2013 (see this Cooley News Brief), unsuccessful Congressional efforts in 2019 and 2021 (see this PubCo post and this PubCo post), as well as recommendations from the SEC Investor Advisory Committee last year (see this PubCo post). Indeed, concerns have also been expressed about other vehicles that may inadvertently permit companies and insiders to opportunistically trade on the basis of MNPI with little transparency. For example, issues have been raised about “spring-loaded” awards to executives, that is, awards made in coordination with the release of MNPI. The concern accelerated following events involving Eastman Kodak Co.’s stock. Kodak’s stock surged in July 2020 to its highest level in six years shortly after the company and a federal agency announced the company was set to receive a $765 million loan to help make drugs to protect against coronavirus. Kodak handed out options to executives the day before the loan was officially announced. Those options, some of which vested the day they were granted, soared in value with the stock.” The WSJ reported that one executive “stood to reap more than $95 million from the stock increase if he had exercised options at then-current prices,” although he did not in fact exercise at the time. Then, the SEC’s Office of the Chief Accountant and Corp Fin released Staff Accounting Bulletin No. 120, which provided guidance about proper recognition and disclosure of compensation cost for “spring-loaded” awards made to executives. (See this PubCo post.)

Issues have also come to light about the potential for opportunistic timing of executive gifts of shares while aware of MNPI. As reported in this article in the WSJ, a new academic study looked at “insider giving,” or, as the study authors described it, “opportunism posing as, or at least muddled with, ordinary philanthropy.” In essence, according to the WSJ, with insider giving, the donor “tim[es] the donation of a stock to a charity around inside information about the stock. That way, you take a tax deduction before bad news sends the share price tumbling or after good news sends the price higher—and the gift delivers a bigger deduction than you would have gotten otherwise.” The donation is not only tax deductible, it’s also exempt from capital gains tax that would be due on the appreciation in value upon the sale. The study authors argued that the practice is “far more widespread than previously believed,” and relied on by insiders, including large investors. Insider giving, they concluded, “is a potent substitute for insider trading.” (See this PubCo post.)

Collectively, the SEC’s new rules are designed to address these concerns by filling those “potential gaps” and, according to the press release,  by “strengthen[ing] investor protections concerning insider trading and [helping] shareholders understand when and how insiders are trading in securities for which they may at times have material nonpublic information.”

The final rules

According to the fact sheet,  the following are the key changes to the affirmative defense under Rule 10b5-1(c)(1):

  • “A cooling-off period for directors and officers of the later of: (1) 90 days following plan adoption or modification; or (2) two business days following the disclosure in certain periodic reports of the issuer’s financial results for the fiscal quarter in which the plan was adopted or modified (but not to exceed 120 days following plan adoption or modification) before any trading can commence under the trading arrangement;
  • A cooling-off period of 30 days for persons other than issuers or directors and officers before any trading can commence under the trading arrangement or modification;
  • A condition for directors and officers to include a representation in their Rule 10b5-1 plan certifying, at the time of the adoption of a new or modified plan, that: (1) they are not aware of material nonpublic information about the issuer or its securities; and (2) they are adopting the plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5;
  • A limitation on the ability of anyone other than issuers to use multiple overlapping Rule 10b5-1 plans;
  • A limitation on the ability of anyone other than issuers to rely on the affirmative defense for a single-trade plan to one such plan during any consecutive 12-month period; and
  • A condition that all persons entering into a Rule 10b5-1 plan must act in good faith with respect to that plan.”

You’ll note that some of the changes in response to comments include shortening of the proposed cooling-off period for directors and officers (along with adding a variable component), adding a shorter cooling-off period for persons other than officers and directors and issuers and elimination entirely of the proposed cooling-off period for issuers. In fact, the application of several of the proposed requirements has been eliminated for issuers, including the limitation on the ability to use single-trade plans and multiple overlapping plans. Note also that the final rules narrow the concept of “modification” for purposes of the cooling-off period, providing that “modifications that do not change the sales or purchase prices or price ranges, the amount of securities to be sold or purchased, or the timing of transactions under a Rule 10b5-1 plan…will not trigger a new cooling-off period.” The final rules also apply the overlapping and single-trade plan limitations to anyone (other than issuers) and include some exceptions, including an exception for qualified “sell-to-cover” transactions (sales to cover tax withholding obligations). In addition, the good-faith requirement no longer refers to “operate” in good faith; it has now been changed to “act” in good faith. The requirement to include a good-faith representation in the plan, as opposed to the proposed separate certification, is also a change from the proposal.

According to the fact sheet, the final rules also impose several new disclosure requirements:

  • “Quarterly disclosure by registrants regarding the use of Rule 10b5-1 plans and certain other written trading arrangements by a registrant’s directors and officers for the trading of its securities;
  • Annual disclosure of a registrant’s insider trading policies and procedures;
  • Certain tabular and narrative disclosures regarding awards of options close in time to the release of material nonpublic information and related policies and procedures;
  • Tagging of the required disclosures; and
  • A requirement that Form 4 and 5 filers indicate by checkbox that a reported transaction was intended to satisfy the affirmative defense conditions of Rule 10b5- 1(c).”

In addition, gifts of securities that were previously permitted to be reported on Form 5 will now be required to be reported on Form 4.

The requirement to provide tabular disclosure regarding option grants has been shortened from the proposed 14 days before or after the release of MNPI to a period of four business days before and one business day after the release. The final rules also did not adopt the proposed requirement to provide a description of contracts, instructions or plans of issuers, eliminated from the proposed description of material terms the need to address pricing terms and added a definition of “non-Rule 10b5-1 trading arrangement.”

Effective dates

The final rules will become effective 60 days following publication of the adopting release in the Federal Register. There are several compliance dates applicable to the different components of the rules.

  • Section 16 reporting persons will be required to comply with the amendments to Forms 4 and 5 for reports filed on or after April 1, 2023.
  • Issuers will be required to comply with the new disclosure requirements in periodic reports on Forms 10-Q, 10-K, and 20-F and in any proxy or information statements in the first filing that covers the first full fiscal period that begins on or after April 1, 2023.
  • Smaller reporting companies will have an additional six months to comply with the additional disclosure requirements.

In addition, with regard to pre-existing plans, the release provides that the amendments to Rule 10b5-1(c)(1) “would not affect the affirmative defense available under an existing Rule 10b5-1 plan that was entered into prior to the revised rule’s effective date, except to the extent that such a plan is modified or changed in the manner described in Rule 10b5-1(c)(iv) [amount, price or timing] after the effective date of the final rules. In that case, the modification or change would be equivalent to adopting a new trading arrangement, and, thus, amended Rule 10b5-1(c)(1) would be the applicable regulatory affirmative defense that would be available for that modified arrangement.”

At the open meeting

There were no fireworks—at least not for this part of the meeting.

Commissioner Hester Peirce supported the final rules, but without much enthusiasm—the rules are “more prescriptive and restrictive” than she would have preferred, but she supported it “for likely doing more good than bad.” She approved of the changes from the proposal related to elimination of the application to issuers of many of the rules, elimination of the requirement to disclose plan pricing information, the new definition of a non-10b5-1 plan and the more reasonable scoping of some of the disclosure requirements. However, she still considered the rule to be too restrictive in many respects. She questioned the need for quarterly disclosure about non-10b5-1 plans, the need to file insider trading policies on EDGAR (as opposed to a website post), the two-business-day requirement to report gifts on Forms 4, and the absence of a hardship exemption.  She also criticized the failure to reexamine the requirement that individuals not be aware of MNPI when they entered the plan, even if the MNPI became public before trading under the plan. She also considered the cooling-off periods to still be too long, the “act in good faith” condition to be unnecessary, and the “granular tabular requirement” to be “more noise than signal.” Other than that,  she believed that “addressing the kind of regulatory gaps that may have enabled the abuse of 10b5-1 plans is an excellent example of what should occupy the Commission’s rulemaking agenda.”  Although some of the policy choices were not to her liking, she was pleased that that she and her colleagues “were able to settle on a final rule that I could support.”

Commissioner Caroline Crenshaw observed that, under the original 10b5-1 rules adopted 20 years ago, the plans “could be modified with ease, and without public disclosure.  Because the plans were so flexible, executives could avail themselves of the affirmative defense, while at the same time amending their plans in advance of corporate announcements that would likely move stock prices. As written, those rules have ceased to provide appropriate investor protection and, data show, have routinely been abused.”  The protections provided by the new rules “should help limit the scope of 10b5-1 plans to situations where insiders are truly trading without the unfair benefit of material non-public information, and protect against opportunistic trading.  And, in so doing, they should help bolster confidence to the public and the market that the proverbial deck is not stacked in favor of the house.”

As noted above, Uyeda was highly complimentary of how well the process had worked, highlighting the modifications made in response to comments, such as the phase-in for SRCs and the elimination of the cooling-off period for issuers. He noted that the process started with a “detailed comment summary” that helped his understanding of commenters’ issues and ultimately “facilitated thoughtful conversations” with fellow commissioners and staffs “to help outline a final rule that the Corporation Finance staff could further develop.”  He observed that 10b5-1 plans can provide some benefits, such as decreasing market volatility and allowing employees to “monetize equity compensation while complying with the insider trading laws”; limiting these plans could make that compensation less valuable. In that regard, he did express some concerns. While he recognized the basis for the rules applicable to overlapping plans and single-trade plans, he worried that the “final rule’s use of prophylactic prohibitions to address both situations may unnecessarily restrict the use of overlapping plans or single-trade plans established for legitimate reasons.” He also questioned whether the “broad concept of ‘good faith’”—an “inherently subjective determination”—could, in hindsight, create uncertainty, making amended rule 10b5-1 “difficult to implement.”  With respect to the use of XBRL, he criticized the “random and piecemeal” approach to its implementation.  Finally, he observed that the amendments to Reg S-K Item 402 were the “third change to that item since I became a commissioner five-and-a-half months ago.  He was “puzzled” by the additional requirement: the narrative was arguably already required by CD&A and the tabular information “is otherwise publicly available.  Before we reach the end of the alphabet for Item 402, I hope that the Commission carefully weighs the effectiveness of future executive compensation disclosure versus its costs.” While Uyeda supported the final rules, he hoped that “market participants will provide the Commission with feedback on whether the right balance was struck.” 

In his statement, Commissioner Jaime Lizárraga observed that “[i]nsider trading is not a victimless crime. It erodes trust in our markets, undermines market integrity, distorts shareholder value, and harms investors. When ordinary investors see that corporate executives can legally manipulate the rules for their own benefit and, in doing so, misuse material, non-public information without consequences, it raises valid questions about whether these practices undermine fairness and transparency in our markets….Closing some of the rule’s loopholes, as we’re doing today, will provide investors with the confidence that there’s a level playing field.”  The rule in place today, he said, does not require much information about the use of 10b5-1 plans, which “prevents investors from assessing whether corporate insiders may be misusing material, non-public information for personal gain, which undercuts the rule’s effectiveness. To be clear, the confidential information of issuers belongs to the company and its shareholders, not to insiders, so investors have a right to understand how issuers protect material, non-public information from being misused.”

Happy Holidays!

Posted by Cydney Posner