New disclosure requirements
On 15 December 2021 the Securities and Exchange Commission (SEC) announced proposed changes to Rule 10b5-1 intended to drive change in the way Rule 10b5-1 plans are currently used.
Recent comments by former SEC Chair Clayton and current SEC Chair Gensler called renewed attention to Rule 10b5-1 plans, which had also received recent legislative interest in Congress, contributing to the current rule proposal. The SEC stated that the underlying purpose of the proposed rule was to address "loopholes in the rule that allow corporate insiders to unfairly exploit informational asymmetries". In essence, the SEC appears to believe that corporate insiders are abusing the use of Rule 10b5-1 plans to trade on material non-public information (MNPI). The new requirements for Rule 10b5-1 plans and related disclosures are intended to address the perceived abuses. The proposed rule also adds new related disclosure requirements designed to address what the SEC believes are widely prevalent practices of misusing MNPI to "spring-load" grants of equity compensation and to improperly time and report gifts of stock.
Upon the fulfilment of certain requirements, the current Rule 10b5-1 provides corporate insiders and companies that enter into a binding written plan to buy or sell securities at a future date with an affirmative defence against insider trading liability. The necessary requirements for a plan that meets Rule 10b5-1 are the following:
- the plan must be adopted when the corporate insider or company is not aware of MNPI;
- the plan specifies the amount of securities to be purchased or sold and the price and date when such transactions should occur or provides a formula or algorithm for determining the price and date;
- the plan does not allow the corporate insider or company the ability to influence how or when trades are made under the plan; and
- the plan was entered into in good faith.
A Rule 10b5-1 plan allows a corporate insider or a company, at a time when they (or the company) do not have MNPI, to direct a broker to sell securities over a period of time according to a defined set of parameters. Many officers and directors of large and small public companies enter into Rule 10b5-1 plans to manage the sales of their holdings in the company. Officers and directors use these plans for the very reason Rule 10b5-1 was implemented in the first place – to insulate them from challenges of insider trading. These plans are generally entered into with brokers who take the requirements of Rule 10b5-1 seriously. Companies similarly enter into Rule 10b5-1 plans in connection with share repurchase programmes.
The proposed rules can be broken down into two parts. The first part includes the proposed amendments to Rule 10b5-1 that make changes to the terms of the plans that will benefit from the affirmative defence. The second part includes the new disclosure requirements relating to Rule 10b5-1 plans and a range of other related practices.
Changes to Rule 10b5-1 plan requirements
Currently, an insider does not need to wait to make a trade under a newly adopted or modified Rule 10b5-1 plan, meaning that trades under a plan can occur immediately. Although the rule currently requires that the insider enter into a plan without awareness of MNPI, the SEC believes that the addition of a cooling-off period would reduce the risk that an insider is adopting or modifying a Rule 10b5-1 plan on the basis of MNPI. The proposed rule includes a 120-day cooling-off period for officers and directors and a 30-day cooling-off period for companies after the adoption or modification of a Rule 10b5-1 plan. The affirmative defence would only apply to officers, directors and companies that comply with these cooling-off periods. The SEC explains that it chose a 120-day cooling off period for officers and directors because it would span an entire quarter, such that no trading could occur under a Rule 10b5-1 plan until the financial results associated with that quarter are announced. The proposed rule does not provide an explanation for the longer cooling-off period for officers and directors as compared to issuers.
The proposed rule clarifies that the SEC's position is that cancelling a trade under a Rule 10b5-1 plan is a deemed termination of the entire plan, which would result in the application of the proposed cooling-off periods. The purpose of this is to deter selective cancellation of a trade because upon cancellation they would be subject to a cooling-off period before a new or modified plan could be adopted.
Director and officer certifications
A cornerstone of the affirmative defence is that the corporate insider is not in possession of MNPI at the time of the adoption of a Rule 10b5-1 plan. To reinforce this obligation, the SEC proposes to require officers and directors to certify that:
- they are not aware of any MNPI at the time they adopt or modify a Rule 10b5-1 plan; and
- they are adopting the contract, instruction or plan in good faith and not as an avoidance scheme.
This new requirement would apply to only officers and directors. The certification would not need to be filed with the SEC, but a copy would be required to be maintained by the officer or director for 10 years.
The proposed rule states that this requirement does not provide an independent basis of liability, it merely underscores the director's or officer's awareness of the law and their obligations. As the elements of the certification are already a basis for the existing requirements of a valid Rule 10b5-1 plan and most plans from brokers include similar representations, this part of the proposal appears designed to simply reinforce a director or officer's understanding of the law each time they adopt or modify a Rule 10b5-1 plan.
Restriction on multiple Rule 10b5-1 plans
The SEC has identified a concern that corporate insiders enter into multiple Rule 10b5-1 plans at the same time to strategically execute trades under one plan and terminate trades on another to exploit MNPI. There are no restrictions on corporate insiders or companies from using multiple overlapping Rule 10b5-1 plans. To address this issue, the SEC proposes eliminating the ability of insiders to rely on the affirmative defence if they maintain multiple overlapping Rule 10b5-1 plans for the same class of securities. Many companies do not permit officers and directors to enter into overlapping Rule 105b-1 plans as part of their trading policies.
This restriction would not apply to share transactions where securities are issued directly from the company (eg, participation in employee stock ownership plans or dividend reinvestment plans), which are not executed on the open market. The SEC has sought comments specifically on how this change would affect practices regarding tax- qualified plans and withholding on equity compensation (eg, stock options and restricted stock unit).
The SEC is also proposing to restrict the use of single trade Rule 10b5-1 plans by limiting the availability of the affirmative defence to only one single-trade plan per 12-month period.
Amending good faith requirement
As outlined above, corporate insiders must "enter into" 10b5-1 trading arrangements in good faith and not as a part of a plan to evade compliance with 10b5-1. To address the SEC's concern regarding insiders manipulating the timing of the release of MNPI to coincide with their predetermined Rule 10b5-1 plan trades, it proposes adding the explicit requirement that the plan be "operated" in good faith. The requirement is intended to address the SEC's concern that corporate insiders will time the release of MNPI in accordance with trades under a plan, which would not be "operating" the plan in good faith. Interestingly, the proposed rule suggests that the termination or modification of a plan could be considered not operating the plan in good faith. This will be an important clarification to seek in any final rule.
Rule 10b5-1 plan and other trading arrangement disclosures
Currently, there are no mandatory disclosures relating to the use of Rule 10b5-1 plans and other trading arrangements for corporate insiders and companies. The proposed rule introduces a new item 408(a) under Regulation S-K that would require quarterly disclosure of the use of Rule 10b5-1 and other trading arrangements by a company and its directors and officers for the trading of the company's securities. Companies will have to include these disclosures in its form 10-Q and form 10-K (for the fourth fiscal quarter) if, during the quarterly period covered by the report, the company, or any of its section 16 officers or directors adopted or terminated a Rule 10b5-1 plan or any other arrangement to transact securities of the issuer even if the arrangement is not intended to satisfy Rule 10b5-1.
In connection with plans that were adopted or terminated by the company during the quarter, the proposed rule would require a company to disclose the material terms of any plan, including:
- the date of adoption or termination;
- the duration of the contract, instruction or written plan; and
- the aggregate amount of securities to be sold or purchased pursuant to the contract, instruction or written plan.
In connection with plans that were adopted or terminated by an officer or director during the quarter, the proposed rule would require a company to disclose the material terms of any plan, including:
- the name and title of the director or officer;
- the date on which the director or officer adopted or terminated the contract, instruction or written plan;
- the duration of the contract, instruction or written plan; and
- the aggregate number of securities to be sold or purchased pursuant to the contract, instruction or written plan.
It is unclear whether the specific items identified above are all of the "material terms" of the plan that are required to be disclosed or whether each company will have to assess whether, in any particular situation, other terms of the plan are material, such as the time period that the transactions occurred in or the prices.
These disclosures are intended to allow investors to better evaluate insider trading compliance and facilitate oversight of the company to prevent non-compliance. Given the heightened disclosure burden, some corporate insiders might seek to enter into trading arrangements outside the scope of Rule 10b5-1. Note, however, that the same disclosure requirements would apply to the adoption or termination of other pre-planned trading contracts, instructions or plans that do not satisfy the conditions of Rule 10b5-1(c)(1), but through which the company, officer or directors seek to transact in the company's securities.
Insider trading policies
Under the existing disclosure regime, public companies are not required to disclose their insider trading policies or procedures. While many public companies have adopted such policies and procedures and some post these policies on their website, there is no affirmative requirement to do so.
To enhance investors' understanding of such insider trading policies and procedures, the SEC proposed new item 408(b) under Regulation S-K to require annual disclosure of a registrant's insider trading policies and procedures.
The proposed rule would require a company to disclose whether it has adopted insider trading policies and procedures to govern the purchase and sale of its securities by directors, officers or employees, or the company itself, that are reasonably designed to promote compliance with insider trading laws and applicable listing standards. The proposed rule would also require companies to disclose these policies and procedures but does not indicate whether posting on the company's website will satisfy this requirement.
If a company has not adopted insider trading policies and procedures, the company would have to explain why it has not done so.
These disclosures would be required in annual reports on forms 10-K and 20-F as well as proxy and information statements on Schedules 14A and 14C. Furthermore, the proposed rule includes new item 16J to form 20-F, requiring foreign private issuers to provide the same annual disclosure.
Given the variety of such policies and procedures among public companies, the proposed rule does not specify what information in the insider trading policies should be disclosed. The proposed rule, however, does provide some guidance on such disclosures. The proposed rule states that the goal of the requirement is to provide detailed and meaningful information for investors to assess the sufficiency of insider trading policies and procedures. For example, among other things, such information may highlight specific policies for evaluating certain transactions or internal processes for documenting and approving them.
Notably, the proposed disclosures regarding insider trading policies that would be required in forms 10-K and 20-F would also be subject to the certifications required by section 302 of the Sarbanes-Oxley Act.
Disclosure of option grant timing
Under current executive compensation disclosure requirements in item 402 under Regulation S-K, compensation-related equity interests are required to be presented in a tabular format and accompanied by appropriate narrative disclosure.
The SEC recognises that there is a lack of transparency around the timing of grants of equity to employees. In particular, the SEC is concerned about practices of making grants of equity in advance of the release of positive MNPI ("spring-loading") and delaying grants of equity until after the release of negative MNPI ("bullet-dodging"), which, in both cases, would allow the recipients of the grants to benefit from MNPI. Thus, the SEC has proposed new item 402(x), which would include a new table to disclose option awards to named executive officers and directors made 14 calendar days before or after the release of MNPI. The table would require the disclosure of the following for each option award:
- the number of underlying securities;
- the date of grant;
- grant date fair market value;
- exercise price; and
- market price of the underlying security the trading day before and after the disclosure of MNPI.
The proposing release defines the release of MNPI as the filing of periodic reports, share repurchases and the filing or furnishing of a Form 8-Ks that contains MNPI. Interestingly, the rule proposal does not capture MNPI that is released in a press release.
In addition, item 402(x) would require narrative disclosure on an issuer's policies and practices on option grants and disclosure of MNPI. The disclosure would provide a summary of the consideration of MNPI by the board or compensation committee in its decisions on timing of equity awards. This could be included in an issuer's compensation discussion and analysis (CD&A).
The additional disclosure would be required in annual reports on form 10-K and proxy statements and information statements relating to director elections, the approval of compensation plans and solicitations of advisory votes on executive compensation.
Notably, the new rule would be applicable to smaller reporting companies and emerging- growth companies as well, with some limitations.
Amendments to forms 4 and 5 related to use of plan
Individuals subject to section 16 reporting obligations must file a form 4 or 5 to disclose changes in their beneficial ownership. In a December 2020 Proposing Release, a voluntary checkbox was proposed for inclusion in forms 4 and 5 to disclose when a transaction "was made pursuant to a contract, instruction or written trading plan for the purchase or sale of equity securities of the issuer that satisfies the conditions of Rule 10b5-1(c)". Many filers are already making this voluntary disclosure and a checkbox would streamline the process. The SEC proposes making this checkbox mandatory.
The new checkbox would require disclosure of:
- whether the sale or purchase is pursuant to a Rule 10b5-1 plan;
- the adoption date of the Rule 10b5-1 plan; and
- an optional space for additional information.
The SEC also proposes including a second optional checkbox that filers could use for transactions "made pursuant to a pre-planned contract, instruction, or written plan that is not intended to satisfy the conditions of Rule 10b5-1(c)".
Form 4 gift disclosure
Currently, corporate insiders may disclose bona fide gifts of equity securities on a form 5 on a delayed reporting schedule (within 45 days after the issuer's fiscal year). This has resulted, in certain circumstances, in the corporate insider reporting the gift more than a year after the gifting occurred. The SEC believes that the delay in reporting may have led to abuse, for example, by backdating a gift for maximum tax benefit. The proposed rule requires reporting of bona fide gifts of equity securities on form 4 before the end of the second business day following the transaction, thus accelerating disclosure to a time close to the occurrence.
The proposed rule could change the way corporate insiders and companies use Rule 10b5-1 plans and it may push some to not enter into these plans at all. If the proposed rules are adopted, companies and corporate insiders would need to review their current practices regarding 10b5-1 plans and make appropriate changes to maintain the affirmative defence.
Some of the proposed changes are largely consistent with existing mainstream practices, such as the restrictions on multiple plans. The cooling-off period will likely be viewed as excessively long for most officers and directors. And, if a termination of a plan is deemed to violate the new, broader good faith requirement, many officers and directors may not see the benefit of entering into a plan at all.
The new disclosure requirements may create the biggest challenge for corporate insiders. The proposed rules would add significant annual and quarterly disclosure obligations for companies regarding their Rule 10b5-1 plans. Many corporate insiders will be reluctant to disclose the aggregate number of shares they intend to sell under a plan. Because this requirement would apply whether or not the plan is intended to comply with Rule 10b5-1, it could mean corporate insiders will not use plans at all. That would create a new burden on the internal lawyers and compliance personnel, who are, in many companies, required to clear every trade an insider makes.
The new item 408 disclosure obligations related to equity compensation grants and MNPI will add to the already daunting challenge of information gathering that is part of the proxy statement drafting process, but, for most companies, the disclosures should not be viewed as troubling.
While most companies have insider trading policies and option grant practices that are largely consistent with the practices that the SEC is intending to promote, these policies have often not been prepared with a view to public disclosure. In some cases, companies would need to formalise written disclosures of policies and practices relating to the oversight of insider trading and track the disclosure of MNPI in combination with the grant of equity awards. Companies will also have to tag the information specified by the new items 408 and 402(x) using inline extensible business reporting language in accordance with the existing rules.
Requiring disclosure in these areas may also be a catalyst for changing policies and practices relating to insider trading, the disclosure of MNPI and equity compensation grant timing. It is thought that the enhanced disclosures may open the door for additional shareholder scrutiny. While some companies already have policies in place and make disclosures that are compliant with the proposed rule, others will need to act.
Also, on 15 December 2021, the SEC proposed a rule outlining new and expansive disclosure requirements relating to share repurchases. As many companies use Rule 10b5-1 plans in connection with share repurchase transactions, the proposed changes to the structure of plans and the related disclosures will be important to watch. For further details, see "SEC proposes new disclosure rules for share repurchases".
The SEC has requested comments on many specific items in the proposed rule as well as general comments. Comments are due 45 days after publication on the federal register.
For further information on this topic please contact Richard Alsop, John Cannon, Doreen Lilienfeld or Gillian Moldowan at Shearman & Sterling by telephone +1 212 848 4000) or email ([email protected], [email protected], [email protected] or [email protected]). The Shearman & Sterling LLP website can be accessed at www.shearman.com.