The US Securities and Exchange Commission proposed amendments to Rule 10b5-1 that would mandate additional disclosure and establish new requirements relating to insider trading. If adopted as proposed, the rule could have substantial impact on the manner in which company executives purchase and sell securities, as well as on issuer repurchases of their securities.
The SEC on December 15 proposed amendments to Rule 10b5-1 (Proposed Rule) that would, among other things:
Comments on the Proposed Rule will be due in late January or early February—45 days after the Proposed Rule is published in the Federal Register.
Rule 10b5-1(c) under the Securities Exchange Act was adopted in 2000 to provide an affirmative defense against insider trading liability for parties that frequently have access to material nonpublic information, including corporate officers, directors, and issuers.
When such a party enters into a trading arrangement as contemplated by the rule—generally referred to as a “10b5-1 plan”—it turns over trading discretion to a third party (generally a broker), often with certain parameters determined by the party establishing the plan, e.g., a maximum purchase price or minimum sale price, or a maximum number of shares that can be bought or sold over a certain period.
By doing so, as long as such party satisfies the requirements of the rule, it will establish an affirmative defense against claims of insider trading, even if the trades called for by the plan occur at a time when the officer, director, or issuer is in possession of material nonpublic information.
Some commentators have long criticized the rule, taking the view that it is subject to abuse by insiders and issuers. The amendments proposed by the SEC are designed to address what the SEC calls “critical gaps in the SEC’s insider trading regime” as well as “to help shareholders understand when and how insiders are trading in securities for which they may at times have material nonpublic information.”
Rule 10b5-1(c)(1) has always had certain conditions that a plan adopter must meet in order to establish the affirmative defense made available by the rule. The proposed amendments would create additional conditions, including the following:
The proposed change requiring a 120-day cooling-off period after a 10b5-1 plan is established or modified before trades can begin represents a dramatic change in the requirements for establishing a Rule 10b5-1 plan, and could have a substantial impact on the desire of insiders to attempt to take advantage of the rule.
It has long been the case that many brokers engaged to manage 10b5-1 plans have required the plans to include a cooling-off period, generally 30 days. Many issuers have also adopted policies requiring their insiders to include such a cooling-off period in their plans. The goal is to create a lag between establishment of the plan and the trading so that any knowledge the insider has at the time he or she establishes the plan will be of diminished value in anticipating market dynamics at the time of the trade(s). Critics of 10b5-1 plans have asserted that insiders were taking advantage of such knowledge—whether or not it constituted material nonpublic information—in establishing their plans.
A required cooling-off period of a minimum of 120 days would represent a dramatic shift from current practice. Such a lengthy period would substantially diminish the ability of the insider establishing the program to have visibility into the market dynamics for the issuer’s securities when the trades will actually take place. While this might address the criticism of the rule described above, it would also have the effect of requiring insiders to establish parameters for trades so far in advance of the trade date that they may have difficulty in anticipating their financial needs or investing strategies, and thus be unwilling to enter into a plan in the first place.
It will be interesting to see the comments that various players in the securities industry will have regarding this element of the rule, that is, whether they believe that it will have a chilling effect on the attractiveness of 10b5-1 plans.
The other proposed amendments to Rule 10b5-1(c)(1) will likely have lesser impact given the following:
In addition to expanding the requirements for use of a 10b5-1 plan, the Proposed Rule contains several enhanced disclosure requirements relating to transactions with and by insiders and issuers, including requirements that:
These changes, if adopted, would likely have varying degrees of impact. Many issuers already make their insider trading policies available on their websites, and those that do not will likely not have major objections to doing so.
The disclosure regarding options has the potential to expose certain option-granting practices that might be deemed abusive “front-running,” but many issuers do not grant options, and many of those that do already have policies that would avoid the kind of grants that the disclosure is designed to expose.
The proposed changes to Section 16 are relatively minor, though some of the statements in the release describing the Proposed Rule are interesting, notably the statement in footnote 56, relating to gifts of securities, that “a donor of securities violates Exchange Act Section 10(b) if the donor gifts a security of an issuer in fraudulent breach of a duty of trust and confidence when the donor was aware of material nonpublic information about the security or issuer, and knew or was reckless in not knowing that the donee would sell the securities prior to the disclosure of such information.”
If the SEC were to begin to pursue enforcement actions with respect to gifts of securities purportedly meeting this description, it could potentially have a substantial impact on how insiders gift securities to charities, which generally do sell gifted shares as soon as they are received.
Potentially far more significant is the proposed requirement that issuers disclose in their quarterly reports the adoption and termination of 10b5‑1 plans by directors, officers, and issuers, as well as the terms of such trading arrangements. Specifically, the required disclosure would include the following:
While some issuers and insiders already disclose the adoption of 10b5-1 plans, many have not typically done so, despite many commentators considering such disclosure a best practice. For those that have disclosed, they often did so with relatively limited detail—not including, in a majority of cases, information about the number of securities to be sold or purchased. Disclosure of plan terminations has been even more rare.
The proposing release asserts that “[s]uch disclosures would allow investors to assess whether, and if so, how, issuers monitor trading by their directors and officers for compliance with insider trading laws and whether their compliance programs are effective at preventing the misuse of material nonpublic information.”
While such disclosure requirements are likely to be less impactful on the use of 10b5-1 plans than the 120-day cooling-off period called for by the Proposed Rule, they will likely be the subject of criticism by many commentators.
The Proposed Rule was promulgated on the same day that the SEC announced several other proposed rules, relating to Fraud, Manipulation, or Deception in Connection with Security-Based Swaps, Money Market Fund Reforms and Share Repurchase Disclosure.
Interestingly, the Proposed Rule was the only one of the proposals that received the unanimous support of the five SEC commissioners—across party lines. Statements by the commissioners indicate that all of them felt that at the very least, the addition of the 120-day cooling-off period was an appropriate modification to Rule 10b5-1.
The three Democratic appointees, including Chair Gary Gensler, expressed a clear view that in order to accomplish its original objective—which at its core was to ensure that insiders and issuers do not have material nonpublic information when they trade in securities—Rule 10b5-1 must be changed. Chair Gensler stated that as constituted, Rule 10b5-1 does not address “potential gaps in [the SEC’s] insider trading regime” and further, that 10b5-1 plans are themselves associated with “potentially abusive practices.” While Commissioner Caroline A. Crenshaw was relatively mild in her criticism of the existing rule (“Experience and academic research supports the need for changes so that it can better achieve its stated goals.”), Commissioner Allison Herren Lee was much more assertive:
. . . [A]cademic studies have produced compelling findings that suggest opportunistic use of 10b5-1 plans, including through such practices as trading shortly after the adoption of plans, and the use of multiple overlapping plans and single-trade plans. This is troubling evidence to suggest Rule 10b5-1 may be used to enable rather than avoid trading on the basis of inside information. Our rule should offer a safe harbor, not a pirates’ cove.
On the other hand, the two Republican appointees, Hester M. Peirce and Elad L. Roisman, cited the 120-day cooling-off period as the primary (in the case of Roisman, the only) element of the Proposed Rule that ultimately led them to support it. Both of these commissioners felt so strongly about adding this provision to Rule 10b5-1—given that it is the provision most likely to have the greatest impact—that it overrode their objections to other of the Proposed Rule’s elements. But they did articulate these objections in their statements.
Commissioner Roisman stated:
In my view, the four-month cooling-off period for individuals will do almost all of the work in ensuring that insiders are not circumventing the purposes of Rule 10b5-1. To say I have reservations about other aspects of the proposal is an understatement. I worry that the additional components of this proposal as it applies to individuals . . . will impose real costs and offer, as far as I can tell, few additional benefits. I hope that commenters will review all aspects of this proposal and send feedback in response to our many questions as well as alert us to the inevitable unintended consequences that could result from implementing these proposed rules as-is.
The comment period—a relatively short 45 days as compared to the more typical 60 days—is likely to be spirited.
As promulgated, the Proposed Rule would, upon adoption, have the general effect of making 10b5-1 trading arrangements less desirable, and those individuals and issuers considering such arrangements would need to weigh additional factors in deciding whether to utilize such arrangements. It will be important to monitor any modifications that are made to the Proposed Rule prior to adoption.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:
David C. Schwartz
Scott D. Karchmer
Matthew H. Lewis