Podcast 09.30.20
Alert
12.28.21
On December 15, 2021, the Securities and Exchange Commission (SEC) proposed changes to Rule 10b5-1 under the Securities Exchange Act of 1934 (Exchange Act) that aim to heighten the requirements to successfully invoke the rule’s affirmative defense and create greater transparency around trades executed pursuant to Rule 10b5-1 trading arrangements. The proposed amendments, which Chair Gensler previewed earlier in 2021, come in the wake of longstanding concerns raised by Members of Congress, courts, scholars, and other commentators regarding executives’ stock transactions or company share buy-backs executed before material public announcements, and concerns regarding perceived loopholes in the rule’s requirements. This alert provides an overview of the current requirements to invoke Rule 10b5-1(c)’s affirmative defense to an insider trading charge, followed by an analysis of the SEC’s proposed amendment, and then concludes with a discussion regarding potential risk-mitigation measures that participants in Rule 10b5-1 plans should consider.
Current Requirements to Invoke the Rule 10b5-1 Affirmative Defense
Because the federal securities laws do not specify the elements of insider trading, liability for trading on the basis of material nonpublic information is generally premised on violations of the antifraud provisions of the Exchange Act (i.e., Section 10(b) and Rule 10b-5 thereunder). In 2000, in an attempt to provide greater clarity regarding the scope of insider trading prohibitions, the SEC adopted Rule 10b5-1, which provides that a person trades “on the basis of” material nonpublic information “if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.”
The rule also provides an affirmative defense to liability when a trade was executed pursuant to a written plan or binding contract adopted when the trader was not aware of material nonpublic information. The plan must specify the amount, price, and timing of the trade, and be insulated from any further influence by the trader (although the current version of Rule 10b5-1 places no explicit limitation on the cancellation of trading plans). In order to qualify for the rule’s affirmative defense, the trader must strictly comply with these requirements and enter into the trading arrangement “in good faith and not as part of a plan or scheme to evade the prohibitions.” Rule 10b5-1(c)(1)(ii).
Although Rule 10b5-1 plans are often associated with corporate officers and directors, the affirmative defense is actually available to any person or entity that complies with the rule’s elements, including private equity funds and investment managers. Additionally, the rule’s protections extend to all types of securities (i.e., beyond equities) and are not limited to publicly traded securities.
Proposed Amendments to Address Perceived Gaps
The proposed amendments are designed to address longstanding concerns that Rule 10b5-1 plans enable individuals to trade on the basis of material nonpublic information. If enacted, the amendments would restrict the availability of the rule’s affirmative defense by imposing a cooling-off period following the adoption or modification of a plan, prohibiting overlapping trading plans, and limiting single-trade plans to one trading plan per 12-month period. The proposed rules would also impose a certification requirement on officers and directors, requiring insiders to affirm that they were not aware of material nonpublic information at the time of a plan’s adoption.
Cooling-Off Periods for Directors, Officers, and Issuers
First, as a condition for directors and officers to invoke the rule’s affirmative defense, the SEC has proposed a 120-day cooling-off period after adoption or modification of any Rule 10b5-1 plan by a director or officer of the company. Under the SEC’s proposal, no trading could occur under any trading arrangement until 120 days following the date of adoption of the plan or modification. According to the SEC’s release, this cooling-off period is designed to prevent insiders from trading on material nonpublic information regarding quarterly earnings announcements because the 120-day restriction would effectively prohibit trading prior to those announcements. Relatedly, the SEC has proposed a 30-day cooling-off period after the date of adoption of trading arrangements by an issuer before the issuer may purchase or sell any securities under the new or modified plan. According to the SEC’s proposing release, a cooling-off period would prevent issuers from conducting stock buybacks while in possession of material nonpublic information.
What constitutes a “modification” to an existing plan was not fleshed out in the SEC’s proposal, but we advise plan participants to construe the term broadly. The SEC’s proposal noted that even the cancellation of a single trade under a Rule 10b5-1 plan constitutes a modification, triggering the cooling-off period.
Under the SEC’s proposal, the cooling-off period requirements are limited to directors, officers, and issuers based on the rationale that classical “insiders” are more likely to have access to unreleased earnings than other market participants. However, there is the potential for expansion of the proposed amendment’s applicability as the SEC requested comments regarding whether the cooling-off period should apply to all traders who rely on the Rule 10b5-1(c)(1) affirmative defense. We expect that the Commissioners and the staff will pay careful attention to any comments received regarding whether a cooling-off period should apply to a broader set of traders.
While cooling-off periods are considered a “best practice” and are common among public companies that have policies governing 10b5-1 trading plans, the proposed 120-day cooling off period is significantly longer than the periods that most companies currently impose. Because many companies discourage or prohibit modification of plans and consider modifications to be equivalent to adoption of a new plan requiring imposition of a new cooling off period, the SEC’s proposal should not have much effect on current common “best practice.”
Prohibition Against Overlapping Plans and Single Trade Arrangements
Currently, the affirmative defense provided by Rule 10b5-1(c) is only available if the purchases or sales at issue are made pursuant to a contract, instruction, or plan. Rule 10b5-1(c)(1) provides that a transaction is not effected pursuant to a contract, instruction, or plan if the trader entered into a corresponding hedging transaction with respect to the securities subject to the plan. The proposed amendments would expand the prohibition against hedges to include barring the use of multiple plans to time different trades around the release of material nonpublic information with the idea that once the trader knows the material nonpublic information he would cancel whichever plan likely will result in the less favorable trade. In other words, the affirmative defense would not be available when a trader maintains another trading arrangement, or subsequently enters into an overlapping trading arrangement for open market purchases or sales of the same class of securities. The proposing release indicates that this prohibition would not apply to transactions directly with the issuer (e.g., employee stock ownership plans). We note that many companies currently prohibit multiple plans, and so the SEC’s proposal would in essence codify a recommended “best practice.”
For trading plans designed to cover a single trade, the SEC proposed limiting the availability of the affirmative defense to one single-trade plan per 12-month period. The affirmative defense would not apply to a single-trade plan if the trader had purchased or sold securities pursuant to another single-trade plan within the last 12 months. The SEC has long considered plans that entail a single trade to be potentially indicative of misconduct, and the proposed amendment would strike a balance between banning such plans outright and allowing market participants to continue to use a perceived “loophole” to engage in opportunistic trading.
The SEC’s proposing release does not contain a definition of “single-trade” plan. Although many traders may construe the phrase to include only ordinary limit orders, market participants that comment on the proposed amendments should consider providing the SEC with feedback regarding the scope of a “single trade” (e.g., whether a series of related acquisitions or divestitures could constitute a “single trade”).
Director and Officer Certification
The SEC has also proposed a requirement that, upon adoption or modification of a trading arrangement, directors and officers certify in writing that they are not aware of material nonpublic information about the issuer or its securities, and that they are adopting the plan in good faith and not to evade securities laws. The proposed amendment would impose a ten-year record retention requirement for any director or officer who seeks to rely on Rule 10b5-1’s affirmative defense. The SEC has also indicated that the proposed certification would not be an independent basis of liability under Section 10(b) and Rule 10b-5, but would instead serve to “underscore the certifiers’ awareness of their legal obligations under the federal securities law related to the trading in the issuer’s securities.” Officers and directors should note that even if the proposed certification does not provide for liability under the antifraud provisions, filing false certifications could constitute a violation of the book-and-records provisions of the Exchange Act.
Proposed Enhanced Disclosure Requirements
Currently, with the exception of Form 144’s requirement that sellers disclose the date on which a Rule 10b5-1 plan was adopted, there are no mandatory disclosure obligations regarding the use of Rule 10b5-1 trading arrangements. The SEC has made several proposals to address this reporting gap in an effort to minimize the information asymmetry between ordinary investors and company insiders. First, the proposed rules would require that issuers disclose in their Form 10-Qs the existence of all Rule 10b5-1 plans and other related trading arrangements with officers, directors, or the company itself, including information regarding their adoption, modification, and termination.
Relatedly, under the SEC’s proposal, issuers will be required to annually disclose their insider trading policies in their Form 10-Ks or Form 20-Fs, as applicable. If an issuer has not adopted an insider trading policy, it will be required to explain why it has not done so. The proposed amendments would require issuers to disclose in their Form 10-Ks, as well as proxy statements and statements related to the election of directors and executive compensation, stock option and stock appreciation awards made within two weeks of the public announcement of any material nonpublic information. The amendments also would require that issuers disclose the details of the options (including amount, fair value, and price of the underlying securities), and the market price of the underlying securities the trading day before and after disclosure of the material nonpublic information.
On Form 4 and Form 5, which must be completed by principal shareholders (i.e., any person or entity that directly or indirectly owns more than ten percent of a class of registered equity securities) in addition to corporate directors and officers, the SEC proposed the addition of a check box by which filers must indicate whether a transaction reported was made pursuant to a trading plan. We note that this requirement comports with current industry best practices and is also required by many broker-dealers that administer Rule 10b5-1 plans. In addition, under the SEC’s proposal, bona fide gifts of securities will no longer be reported on Form 5, but will be required to be reported on Form 4, before the end of the second business day following the date of the gift.
Risk Mitigation Measures
Even prior to the announcement of the proposed amendments to Rule 10b5-1, Chair Gensler had indicated that Rule 10b5-1 plans and insider trading, generally, would be regulatory and enforcement priorities of the SEC under his leadership. It is also worth noting that the SEC’s proposed amendments have unanimous support from its five Commissioners, a majority of whom the prior presidential administration appointed. For these reasons, and in light of the overall aggressive enforcement climate under Chair Gensler, participants in Rule 10b5-1 trading plans should consider proactive risk mitigation measures, including implementing the substance of the SEC’s proposed amendments before the SEC decides whether to approve them.
As an initial matter, it is worth reiterating that in order to invoke the protections of Rule 10b5-1’s affirmative defense, a trader must comply strictly with all elements of the rule. Accordingly, market participants should review their policies and procedures regarding trading arrangements to ensure that any plans—and the processes for adopting and modifying any plan—satisfy every requirement under Rule 10b5-1(c).
Officers and directors of issuers generally rely on counsel to oversee compliance with Rule 10b5-1 and the creation and modification of Rule 10b5-1 plans. Other traders that avail themselves of the rule’s protection should likewise ensure that counsel or compliance personnel are involved at all stages of the process. Relatedly, private equity funds that utilize Rule 10b5-1 plans should work with compliance and legal to evaluate how the proposed prohibition against overlapping trading arrangements will impact their trading strategies.
Mindful that regulated entities have a duty to reasonably supervise their personnel with an eye toward preventing and detecting potential misuse of material nonpublic information, investment firms should evaluate their compliance with Rule 10b5-1 in the context of their broader efforts to comply with insider trading prohibitions. Investment advisers should use this as an opportunity to review their policies, procedures, systems, and controls with respect to insider trading generally. And in light of the unique risks posed by Rule 10b5-1 plans and the associated evolving regulatory requirements, regulated entities should consider providing mandatory training for any associated or registered personnel intending to utilize a trading arrangement.
Finally, regulated entities should pay careful attention to the duration and scope of any plans. The SEC’s proposing release suggests that the agency views relatively short plans with considerable skepticism, and such plans could be perceived as an attempt to circumvent Rule 10b5-1’s requirements. Market participants should also be judicious in their use of Rule 10b5-1 plans. Trading plans should only include securities for which there is a reasonable likelihood that the participant will acquire confidential information. In the case of private funds, plans should likely cover the securities of portfolio companies.
The SEC has provided a 45-day comment period for the proposed amendments, a relatively brief window given the complex and important issues raised by the proposal. Market participants—including both classical “insiders” and other traders—that rely on Rule 10b5-1 plans should strongly consider sharing their perspectives with the SEC as the agency sets the ground rules that will apply to these trading arrangements.