Upcoming Changes to Rule 10b5-1:
The SEC is seeking to propose four key changes to executive stock trading plans under Rule 10b5-1 in October. Its Chairman, Gary Gensler, reported that the SEC is considering “freshen[ing] up Rule 10b5-1 after twenty years” to address insider trading concerns on June 7, 2021. Gensler’s comments come after a year of heightened insider trading reporting and the release of new research conducted by Stanford University and the Wharton School of the University of Pennsylvania finding that 10b5-1 plans have been used by executives to engage in “opportunistic, large-scale” sales of company stock. Gensler remarked the current plans under Rule 10b5-1 have led to a “real crack in our insider trading regime,” which he seeks to address in the upcoming months.
Background
Currently, Rule 10b5-1 permits corporate insiders with access to material non-public information (MNPI) to adopt stock trading plans with predetermined stock trading schedules. Rule 10b5-1 plans provide corporate insiders an affirmative defense against insider trading and market manipulation claims under The Exchange Act of 1934 §10(b) and Rule 10b-5 when entered into in good faith. Rule 10b5-1 requires a written plan that includes the date, amount and price of securities to be bought or sold. Alternatively, the written plan can specify a formula or algorithm to determine the amount, price and date of the sale or purchase. Once the plan is submitted, trades can occur immediately and insiders who do not have MNPI may modify plans at any time, while insiders with MNPI may cancel their plan at any time. Gensler noted in his remarks earlier this month that canceling or amending such plans, which is permitted under the current rule, calls into question if the plans were entered into in good faith.
The SEC’s heightened scrutiny comes after Stanford’s recent research found trends in 10b5-1 plans that allowed corporate insiders to avoid significant losses and foreshadowed considerable stock price declines that were well in excess of industry peers. Currently, researchers, regulators, and shareholders have a limited understanding of how 10b5-1 plans are used in practice given the lack of public disclosure and transparency of the filing of Form 144. The study noted that the SEC, “strangely, does not require electronic submission of Form 144,” for public availability through EDGAR. Instead, the mailed-in forms are stored in the SEC reading room and destroyed 90 days after receipt. However, despite this shortfall of information, the study was able to analyze 20,000 10b5-1 plans, including their associated adoption dates and trade, between January 2016 to May 2020. The study identified three areas of concern relating to these plans:
- Plans with a short “cooling off” period between plan adoption and trading;
- Plans that only entail a single trade; and
- Plans that involve trading that occurs before a company’s quarterly earnings announcement.
The study found that these plans allowed insiders to avoid losses of 4% relative to industry peers during the six months following the first sale. The study also found that plans that pertained to a single trade were “consistently loss-avoiding regardless of a cooling-off period,” unlike multiple-trade plans with a cooling-off period of a month or more. From their findings, researchers suggested the SEC ban single-trade plans, require Form 144 be electronically filed and posted to the SEC’s EDGAR database, and require the mandatory disclosure of the adoption, modification, suspension or termination of a plan.
Gensler’s concern of public distrust regarding the executive stock trading plan’s ability to create a “loophole” for bad actors who seek to take advantage of the current rule’s flexibility has prompted the upcoming proposal. During his remarks, Gensler reported that 14% of sales of restricted stock are initiated within 30 days, and another two-fifths are initiated within the first two months of a 10b5-1 plan being adopted. Additionally, Gensler fears the rule’s lack of limitations for these plans allows insiders to “mistakenly think they have the option to pick amongst favorable options.”
Four Upcoming Rule Changes:
Gensler has earmarked four changes for October’s proposal in order to facilitate “best practices” for the industry.
- Creating a mandatory cooling-off period: Gensler stated a 4-6-month cooling-off period will likely be proposed and is a recommendation that is backed by the industry.
- Limiting terminations: Insiders with MNPI may cancel plans at any time and Gensler feels this type of information may unfairly influence the decision to cancel the plan.
- Requiring mandatory disclosures: Gensler wants to implement requirements regarding the adoption, modification and terms of the plans to enhance investor confidence in the market.
- Limiting the number of plans: There is currently no limit on the number of Rule 10b5-1 plans for insiders, which creates concern that insiders may cherry pick more favorable plans in this process.
Moving Forward with Next Steps:
Given Rule 10b5-1’s importance to executives, as well as corporations as a compliance mechanism and shield from insider trading claims, corporations and their boards should revisit their own 10b5-1 plans and consider if their practices are in accordance with the industry’s best practices. In making these evaluations, consideration should be given to cooling-off periods, the type of trades that are allowed, and how and when plans are allowed to be modified or canceled.
