- Rule 10b5-1(c) of the Securities Exchange Act of 1934 provides an affirmative defense to insider trading allegations when an employee trades pursuant to certain pre-established conditions.
- Amidst concern that the rule contains loopholes that allow it to be used to evade accountability for insider trading, the SEC issued proposed changes in December 2021.
- The SEC and the U.S. Department of Justice also have been investigating the alleged abuse of 10b5-1 plans. The government requested information from executives early this year, and reportedly is preparing to bring multiple cases.
The Bottom Line
At the close of a year during which the Securities and Exchange Commission levied a record-breaking $6.4 billion in enforcement actions, the agency appears to be targeting prearranged stock-sale programs under which billions of dollars of transactions are conducted annually. Companies use these plans, formed pursuant to Rule 10b5-1 of the Securities Exchange Act of 1934, to reduce the threat of insider trading allegations against corporate insiders. An SEC proposal to amend Rule 10b5-1, as well as recent enforcement activity relating to these plans, suggest that the SEC is concerned that the rule has been misused as cover for insider trading.
The SEC implemented Rule 10b5-1(c) in 2000 as an affirmative defense to insider trading. The defense applies to purchases or sales of securities made (1) pursuant to a binding contract to purchase or sell the security, (2) pursuant to instructions given prior to the instructing person becoming aware of material nonpublic information, or (3) pursuant to a written plan for trading securities. The contract, instruction, or plan must have been given or entered into in good faith. In practice, many issuers have 10b5-1 plans that allow company insiders to trade the issuers' stock according to pre-arranged schedules. The concept behind a 10b5-1 plan is that because employees trade pursuant to the plan they necessarily lack scienter to engage in insider trading.
Rule 10b5-1(c) has long been criticized for containing substantial loopholes, and academic research published by Stanford University in 2021 highlighted key weaknesses that could permit opportunistic trading. Researchers identified three “red flags” for trading plans. First, Rule 10b5-1(c) has no required “cooling off” period, which means that executives can trade under a plan only days after it was adopted. Second, plans can be adopted for the purpose of executing a single trade. And third, trading can begin in the same quarter as the plan was adopted, including before the earnings announcement for that quarter. Others also have identified as problematic the fact that executives can cancel scheduled trades, and can have multiple overlapping plans.
In December 2021, the SEC proposed amendments to Rule 10b5-1(c). The SEC’s proposal would add four requirements to Rule 10b5-1 plans. First, it would implement a cooling-off period. Trading arrangements entered into by officers or directors would have to include a 120-day period before trading could commence. A 30-day cooling-off period would be required for issuers of the relevant security before the issuer could repurchase shares. Second, it would require officers and directors to certify that they are not aware of any material nonpublic information about the issuer or the security at the time of adopting or modifying a trading arrangement. Third, it would prevent the use of the affirmative defense in cases where there are multiple overlapping Rule 10b5-1 trading arrangements for open market trades in the same class of securities. Finally, the proposed rule would limit the use of 10b5-1 plans that pertain to only a single trade. A trader could only use the Rule 10b5-1 defense for one such trade per year. In addition to these added requirements, the SEC’s proposal further emphasizes that the defense only applies to arrangements that are entered into and operated in good faith.
The comment period for these proposed amendments ended in April 2022, so the SEC may implement these changes in the near future.
Meanwhile, the SEC and the DOJ have been investigating the alleged abuse of Rule 10b5-1 plans. The government requested information from numerous unnamed executives early this year, and is reportedly preparing to bring multiple enforcement actions. For example, the SEC instituted an enforcement action against the former CEO and the former president of Cheetah Mobile Inc., a Chinese-based corporation, over their sale of company stock, where the two former executives executed a 10b5-1 plan after learning that revenue from a key advertiser was declining.
Given the Biden administration’s priority of strengthening enforcement and the SEC’s demonstrated interest in Rule 10b5-1 investigations, companies and individuals should proceed with caution and seek guidance from experienced counsel when implementing 10b5-1 plans. The SEC’s proposed rule likely provides a roadmap for adopting plans that will minimize the risk of hitting tripwires and investigative scrutiny.
Attorneys in Ballard Spahr’s Securities Enforcement and Corporate Governance Litigation Group are available to advise businesses on the changes to 10b5-1 plan investigations. Please contact us for more information.
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