SEC Resets 'Set It and Forget It' 10b5 Plans
POMERANTZ MONITOR | SEPTEMBER OCTOBER 2021
On September 9th, the U.S. Securities and Exchange Commission’s (“SEC”) Investor Advisory Committee (“IAC”) adopted new proposed recommendations to overhaul Rule 10b5-1, which the SEC first adopted in 2000 as a framework for insiders of publicly traded corporations to buy and sell securities without running afoul of insider trading laws, compliance rules or the appearance of conflicts of interest, and to set up a trading plan for selling stock they own. Rule 10b5-1 is a clarification of Rule 10b-5, created in 1942 under the Securities and Exchange Act of 1934 in order to explicitly prohibit the use of fraud or deception in connection to the sale or purchase of securities on U.S. exchanges.
Under the terms of Rule 10b5-1, both the seller and the broker making the sales must not have access to any material nonpublic information (“MNPI”). The SEC considers a stock transaction to have been made “on the basis of” MNPI if the trader was “aware” of the MNPI at the time of the transaction. But it also provides an affirmative defense if the transaction was made pursuant to a trading plan that satisfies these conditions: (i) it was adopted in good faith before the insider became aware of MNPI; (ii) it specifies the amount, price, and date of the transactions; (iii) it provides written instructions or a formula that triggers the transactions; and (iv) it does not allow the insider to influence how, when, or whether transactions take place once the plan is established.
Addressing concerns that SEC Chair Gary Gensler first raised in comments to the Wall Street Journal in June, the proposed recommendations seek to “freshen up” Rule 10b5-1, with the goal to reduce the risk that company executives, using private information to opportunistically sell shares of companies they oversee, could invoke this rule as a shield against charges of insider trading. Certain features had “led to real cracks in our insider trading regime,” according to Gensler, and it would be a top priority of the SEC to move quickly to tighten regulations against insider trading.
While the protective trading structure offered to executives under 10b5-1 could continue to meet the intended purpose for good faith transactions, critics pointed to data showing the plans were being used to shield abuse. A 2020 Stanford University study had detailed trends suggestive of abuse, flagging problems with their structure that would continue to frustrate the purpose of these accounts. Calling it a matter of “good corporate hygiene,” the prior SEC Chairman, Jay Clayton, also called for these changes in order to eliminate “any suggestion of impropriety or unfairness.”
Compliance with these plan terms seemed straightforward. To qualify for protection under Rule 10b5-1, executives would enter into a nonbinding contract with a broker third party to execute trades on their behalf and have a “Set it and Forget it” schedule of trades. However, while the expectation was that the executive would rely on Rule 10b5-1 to sell in multiple transactions spread out over time, the reality was starkly different. Because the original rule did not specify a minimum number of transactions, executives could use a newly minted plan for a single trade, as needed. They could have as many plans as they desired to deal on new information and could terminate or modify these at will.
Stanford University’s Rock Center for Corporate Governance, in the aforementioned study, reported that their review of a dataset of over twenty thousand 10b5- 1 plans revealed that “a subset of executives use 10b5- 1 plans to engage in opportunistic, large-scale selling of company shares.” The report described major “red flags ... suggestive of potential abuse” while stating that their findings were also consistent with prior research that suggested “10b5-1 sales systematically precede periods of underperformance and early termination of planned sales systematically precede periods of outperformance.” These trends were suggestive that Rule 10b5-1 plans were being exploited to shield insider trading.
Following Gensler’s directive, a subcommittee of the IAC issued draft recommendations in August. Stating that there was “strong bipartisan support” for revisions to Rule 10b5-1 to “improve transparency regarding insider trades and enable effective investigation and enforcement of violations,” the IAC recommended that the SEC “move quickly to close identified gaps in the current rule.” Among other policy changes, the IAC recommended that insiders or issuers be prevented from having more than one 10b5-1 plan in effect at the same time and would require a cooling-off period from the time of origination or modification.
Under the proposal, executives creating a new 10b5-1 plan or modifying an existing plan would have to endure a “cooling-off” period of at least four months before making trades under the newly adopted or modified plan. The IAC noted that such a cooling-off period would ensure that an insider or issuer could not put in place a plan that trades in the same quarter as its adoption and that limiting the affirmative defense protections to a single plan “would signal to the market that a plan was entered into in good faith.”
The recommended policy also set out additional disclosure requirements including proxy statement disclosure of the number of shares covered under corporate 10b5-1 plans for each executive as well as disclosure (on Form 8K) of the adoption, modification, or cancellation of 10b5-1 plans by an issuer, noting the number of shares covered by such plans. The new rules also extend Form 4 (Statement of Changes in Beneficial Ownership) reporting requirements to all companies – including non-U.S. issuers – with any securities listed on a U.S. exchange.
Approving the IAC’s recommendations in September, Gensler applauded the fast work of the subcommittee, stating “I believe plans under Exchange Act Rule 10b5- 1 have exposed potential gaps in our insider trading enforcement regime…you’ve pointed out some important areas that are in line with what I’ve asked staff to consider in a proposed rulemaking.”