On Jan. 28, 2019, the House of Representatives passed with overwhelming bipartisan support (413 to 3) the Promoting Transparent Standards for Corporate Insiders Act (H.R. 624) (the Act). If passed by the Senate, the Act would direct the SEC to carry out a study to determine whether reforms should be made to Rule 10b5-1 under the Securities Exchange Act of 1934 to prevent insiders from exploiting “loopholes” in the rule to profit from trades made using inside information. The Act is intended to address critics of Rule 10b5-1, who point to studies that claim insiders realize abnormal gains when trading in their company’s securities. If enacted, the Act could lead the SEC to make significant changes to the rule.
Insider Trading Laws and Rule 10b5-1 Trading Plans
Pursuant to Rule 10b5-1, corporate insiders are prohibited from buying or selling securities “on the basis of material nonpublic information.” The rule further clarifies that this standard is breached if an insider is “aware of” such information when the trade in question occurs. However, Rule 10b5-1 also provides for an affirmative defense against a charge of insider trading if the trade in question is made pursuant to a written plan for trading securities that is designed in accordance with Rule 10b5-1(c) (a so-called Rule 10b5-1 plan). Generally, to be effective, a Rule 10b5-1 plan must be established in good faith before the insider becomes aware of material nonpublic information and must specify (i) the amount of securities to be traded, (ii) the price at which the securities may be sold, and (iii) the date of execution, or, alternatively, a formula or algorithm to determine these factors. The plans are widely used by insiders who might regularly have access to material nonpublic information to buy or sell securities, because if properly adopted, the plans provide an affirmative defense against allegations of insider trading, even if the insider was aware of material nonpublic information at the time of the trade.
Questions Surrounding Rule 10b5-1
Despite the soundness of Rule 10b5-1’s intent, a number of articles and studies have raised questions about its efficacy, including findings indicating that executives who trade using Rule 10b5-1 plans have materially better results than those who do not use such plans. The concerns center around several loopholes in the design of the rule. For instance, a Rule 10b5-1 plan can be amended at any time, posing an issue if, for example, an insider could terminate a plan ahead of company news, whether such news is positive or negative. As such, an executive who is scheduled to sell company stock pursuant to a Rule 10b5-1 plan but knows that earnings are strong might try to terminate his or her plan before earnings are released, hold onto the stock, and benefit from the subsequent appreciation in value. Similarly, an executive who knows earnings will be weak might attempt to do the opposite by terminating a plan ahead of a scheduled purchase. Moreover, no disclosure is generally required when an insider enters into, amends or terminates a Rule 10b5-1 plan.
The Act and Its Potential Impact on Issuers and Insiders
If enacted, the Act would direct the SEC to conduct a study to determine whether reforms should be made to Rule 10b5-1. In particular, the Act references the following potential reforms:
- Limiting the times when a 10b5-1 trading plan can be adopted to those windows when an insider is otherwise permitted to trade company securities
- Limiting the ability to adopt multiple 10b5-1 trading plans
- Establishing a mandatory delay between the adoption of a 10b5-1 trading plan and trading
- Limiting the ability to modify or terminate trading plans
- Requiring trading plans and amendments to be filed with the SEC
- Requiring boards of directors of companies to monitor and establish clear-cut policies relating to their plans
In adopting any such reforms, the Act would also require the SEC to consider countervailing factors such as the impact on capital formation and the diminished ability of issuers to attract people who would be considered “insiders.”
For now, regardless of whether the Act is passed by the Senate, we would recommend that issuers review their policies regarding the adoption of Rule 10b5-1 plans, with a focus on requiring that Rule 10b5-1 plans adopted by company insiders contain certain of the above potential reforms and that insiders review their existing plans on the same basis. If used properly, Rule 10b5-1 plans will continue to be an effective and recommended tool for companies and issuers to trade securities in compliance with federal securities laws and company policies.