As the SEC mulls its 10b5-1 proposal (see this PubCo post), neither its Enforcement Division nor the DOJ are waiting around to see what happens. According to Bloomberg, they are using data analytics “in a sweeping examination of preplanned equity sales by C-suite officials.” The question is whether executives “been gaming prearranged stock-sale programs designed to thwart the possibility of insider trading”? Of course, there have been countless studies and “exposés” of alleged 10b5-1 abuse over the years, the most recent being this front-page analysis of trading by insiders under Rule 10b5-1 plans in the WSJ (see this PubCo post). While these concerns have been percolating for quite some time, no legislation or rules have yet been adopted (although several bills have been introduced and the SEC proposed new regs at the end of 2021). Bloomberg reports that these investigations by Enforcement and the DOJ are consistent with the recent “tougher line on long-standing Wall Street trading practices during the Biden era. Federal officials requested information from executives early this year, said one person. They’re now preparing to bring multiple cases, said two other people.”
When the WSJ performs a study and publishes the results on the front page, it often has consequences. Remember the stock option backdating scandal? (See, e.g., this news brief, this news brief and this news brief.) The analysis from the WSJ of executive trading under Rule 10b5-1 plans “shows that executives benefit when sales happen quickly after the plans’ adoption.” In the study, the WSJ analyzed 75,000 10b5-1 plan stock sales by corporate insiders from 2016 through 2021, based on a review of Form 144 filings. The data showed that about 20% of these trades “occurred within 60 trading days of a plan’s adoption. The timing in aggregate made the trades more profitable: On average, those trades preceded a downturn in share price more often than when insiders waited longer to trade, the analysis found. Collectively, insiders who sold within 60 days reaped $500 million more in profits than they would have if they sold three months later, according to the analysis.” (See this PubCo post.)
As noted above, that wasn’t the first study to address problems with 10b5-1 plans—it wasn’t even the first study from the WSJ. In 2012, a study conducted by the WSJ indicated favorable results that appeared to be more than serendipitous from trading by insiders under 10b5-1 plans. 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.)
Potential issues with 10b5-1 plans were spotted relatively soon after the rule was adopted in 2000. As reported in the Washington Post, in remarks delivered in 2007, then-SEC Enforcement Chief Linda Thomsen expressed concern 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, Thomsen said. ‘We’re looking at this hard….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.) She later added that one additional factor the SEC may take into account is the existence of “asymmetric” disclosure, that is, disclosure of entry into the plan without corresponding disclosure of amendments or termination of the plan (which is often the stage at which the alleged abuse occurs).
Other studies have also been conducted. In this paper, Gaming the System: Three ‘Red Flags’ of Potential 10b5-1 Abuse, cited by SEC Chair Gary Gensler in 2021 remarks (see this PubCo post), the authors, from the Rock Center for Corporate Governance at Stanford, examined data from over 20,000 Rule 10b5-1 plans to investigate the extent of insider trading abuse. The study found that some executives did use 10b5-1 plans to conduct “opportunistic, large-scale selling that appears to undermine the purpose of Rule 10b5-1.” Although the authors acknowledged that they could not determine for certain whether any insiders that avoided losses or otherwise achieved “market-beating returns” actually traded on the basis of MNPI, they contended that average trading returns of the magnitude they found in the study “are highly suspect and, as such, these red flags are suggestive of potential abuse.” The authors identified three “red flags” that could be used to detect potentially improper exploitation of Rule 10b5-1:
“1. Plans with a short cooling-off period
2. Plans that entail only a single trade
3. Plans adopted in a given quarter that begin trading before that quarter’s earnings announcement.” (See this PubCo post.)
Bloomberg has observed recent evidence of the investigations, with companies disclosing the receipt of SEC and DOJ subpoenas, including one from a grand jury, “seeking materials concerning the trading activities.” The article also pointed to recent charges against the CEO and the President of Cheetah Mobile, as a possible consequence of this investigation.
The settled SEC Enforcement action against executives of Cheetah Mobile involved sales under a purported 10b5-1 trading plan while in possession of material nonpublic information. Of course, to be effective in insulating an insider from potential insider trading liability, the 10b5-1 plan must be established when the insider is acting in good faith and not aware of MNPI. Creating the plan when the insider has just learned of MNPI, as alleged in this Order, well, kinda defeats the whole purpose of the rule. That’s not how it’s supposed to work, and the two executives charged—the CEO and President/CTO of Cheetah Mobile—found that out the hard way, with civil penalties of $556,580 and $200,254. According to the Chief of the SEC Enforcement Division’s Market Abuse Unit, “[w]hile trading pursuant to 10b5-1 plans can shield employees from insider trading liability under certain circumstances, these executives’ plan did not comply with the securities laws because they were in possession of material nonpublic information when they entered into it.” (See this PubCo post.)
Bloomberg observed that 10b5-1 plans “are appealing to corporations and executives because, if properly used, they can give a solid defense against insider-trading allegations.” As a result, Bloomberg suggested, they have been widely adopted “since the SEC created rules for them two decades ago, and they’re now responsible for thousands of transactions collectively worth billions of dollars annually.” Nevertheless, Bloomberg reported, critics have identified “many possible loopholes,” such as the opportunity for multiple overlapping plans and the absence of required cooling-off periods. Legislation has been introduced a number of times but nothing has been adopted.
The JOBS and Investor Confidence Act of 2018 (the erstwhile JOBS Act 3.0) would have required the SEC to study whether Rule 10b5–1 should be amended in various respects, including to limit the ability of issuers and issuer insiders to adopt multiple, overlapping trading plans and to mandate cooling-off periods. The bill passed the House by a vote of 406 to 4, but made no progress in the Senate. In 2019, the House, with significant bipartisan support, proposed the “Promoting Transparent Standards for Corporate Insiders Act,” which would have required a similar study. (See this PubCo post). In 2021, a bipartisan pair of senators reintroduced the same bill. None of these bills went anywhere. (See this PubCo post.) And in 2021, three Democratic Senators, Elizabeth Warren, Sherrod Brown and Chris Van Hollen, submitted a letter to then-Acting SEC Chair Allison Lee appealing for SEC action on Rule 10b5-1 plans. In support of their request, these Senators cited research suggesting that initial trades set up by 10b5-1 plans often appear to be based on MNPI and that executives modify or cancel their plans “in response to inside information in order to increase their own profits.” (See this PubCo post.)
According to the article, both Gensler and his predecessor, Jay Clayton, “have said the agency’s rules for the plans have led to gaps in its surveillance of potential insider trading.” Almost a year ago, the SEC proposed new rules designed to address some of the concerns about potential abuse of Rule 10b5-1 and to add new conditions to the use of the Rule 10b5-1 affirmative defense and new disclosure requirements.
The SEC’s proposal on 10b5-1 plans includes a number of provisions aimed at addressing problems that have been identified with 10b5-1 plans, among them:
- two new cooling-off periods—a 120-day cooling-off period after adoption or modification for officers and directors and a 30-day cooling-off period for companies;
- written certifications for officers and directors at the time of adoption or modification that they are adopting the plan in good faith are not aware of MNPI about the company or its securities;
- prohibition on multiple overlapping trading arrangements;
- affirmative defense available only for one single-trade plan during any 12-month period;
- requirement that Rule 10b5-1 trading arrangements be entered into and operated in good faith;
- a new checkbox on Section 16 forms to show that the trade was made under a 10b5-1 plan;
- required gift disclosures within two business days (see this PubCo post for a discussion of a study about the potential for opportunistic timing of executive gifts of shares while aware of MNPI); and
- a number of enhanced disclosure requirements, including narrative disclosure about the company’s equity grant policies and practices addressing the timing of grants and the release of MNPI; annual disclosure of insider trading policies and procedures; quarterly disclosure of whether the company or officers or directors adopted or terminated any contract, instruction or written plan to purchase or sell securities of the company, whether or not under Rule 10b5-1, describing the material terms of those trading arrangements; and a new table showing grants to NEOs made within 14 days before or after an issuer share repurchase or the filing of a periodic report or Form 8-K that contains MNPI. (See this PubCo post.)