Yesterday, in remarks before the WSJ's CFO Network Summit, SEC Chair Gary Gensler scooped the Summit with news of plans to address issues he and others have identified in Rule 10b5-1 plans. Problems with 10b5-1 plans have long been recognized—including by former SEC Chair Jay Clayton—so it will be interesting to see if any proposal that emerges will find support among the Commissioners on both sides of the SEC's aisle. In an interview, Gensler also responded to questions about climate disclosure rules, removal of the PCAOB Chair, Enforcement, SPACs and other matters.
Rule 10b5-1 background. Corporate executives, directors and other insiders are constantly exposed to material non-public information, making it sometimes difficult for them to sell company shares without the risk of insider trading, or at least claims of insider trading. To address this issue, Congress developed the Rule 10b5-1 safe harbor. In general, Rule 10b5-1 allows an insider, when acting in good faith and not in possession of MNPI, to establish a formal trading contract, instruction or plan that specifies pre-established dates or formulas or other mechanisms—that are not subject to the insider's further influence—for determining when the insider can sell shares, without the risk of insider trading. To be effective, the contract, instruction or plan must also conform to the specific requirements set forth in the Rule. In effect, the Rule provides an affirmative defense designed to demonstrate that a purchase or sale was not made "on the basis of" MNPI. If a 10b5-1 contract, instruction or plan is properly established, the issue is not whether the insider had MNPI at the time of the purchase or sale of the security; rather, that analysis is performed at the time the instruction, contract or plan is established.
After the plan has been established, there is no requirement for a cooling-off period—that, is the plan can provide for immediate trades. In addition, the insider can modify it, so long as he or she is not aware of MNPI at the time of the modification, and can terminate it at any time—even if the insider is in possession of MNPI at the time. Why is that? Because the termination (and related cancellation of any planned trades) is not "in connection with the purchase or sale of any security." Plans can be used for a single trade, and there is no requirement that multiple trades be spaced apart. An insider can also adopt multiple plans that operate at the same time. Although there are requirements that insiders report transactions on Forms 4 and 144, there is no independent public reporting requirement for 10b5-1 plans (other than the requirement on Form 144 to provide the date of plan adoption if the sale was under a 10b5-1 plan). However, some insiders do provide that information voluntarily. The wide berth the Rule gives executives to conduct transactions under these plans, together with the absence of public information requirements, has long fueled controversy about Rule 10b5-1 plans. In particular, some view the ability to adopt multiple plans and to amend or cancel the plans as providing opportunities to exploit the Rule.
Gensler's view. To Gensler, 10b5-1 plans "have led to real cracks in our insider trading regime," and, as a result, he has asked the staff to make recommendations for a proposal to "freshen up" Rule 10b5-1.
In this paper, Gaming the System: Three 'Red Flags' of Potential 10b5-1 Abuse, cited by Gensler in his remarks, 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."
The study showed that there is substantial variety in the duration of cooling-off periods, including 1% of plans that had no cooling-off period at all and began trading on the same day as plan adoption. About 14% of plans began trading within the first 30 days and 39% within the first 60 days. Only 29% of cooling-off periods were four months or longer. The study also showed a correlation between initial trade size and duration of the cooling-off period, with trades under plans with cooling-off periods of less than 30 days being about 50% larger (median $573,000) than trades under plans with a cooling-off period of six months or more (median $360,000). However, the largest median initial trades (at $619,000) occurred with cooling-off periods of 61 to 90 days and, at 91 to 120 days, the median was $615,000.
Perhaps most interesting, the authors also looked at "loss avoidance," calculated against industry-adjusted stock returns over the six months after the first planned sale, i.e., the greater the negative return following the sale, the greater the loss avoidance. The study found "that trades of plans with short cooling-off periods avoid significant losses and foreshadow considerable stock price declines that are well in excess of industry peers." In addition, the "shorter the interval between plan adoption and the first trade, the more likely it appears that the plan is being used opportunistically. With longer cooling-off periods, opportunistic trading disappears."
In the study, 49% of plans covered only a single trade. Notably, the data showed that trades under single-trade plans were "consistently loss-avoiding regardless of cooling-off period. Single-trade plans with short cooling-off periods exhibited the highest average loss avoidance. (See this PubCo post.)
Below are some of the new limitations Gensler suggests should be considered in a proposal:
- Cooling-off period. Gensler is concerned that the absence of any cooling-off period after adoption of 10b5-1 plans might be perceived by "some bad actors...as a loophole to participate in insider trading. Research has shown that 14 percent of sales of restricted stock in 10b5-1 plans initiate the planned transactions within 30 days of plan adoption, and about two in five plans within the first two months. Former Chair Clayton and Commissioners Allison Lee and Caroline Crenshaw have all advocated four- to six-month cooling-off periods, and Gensler believes that "this approach deserves further consideration."
In a letter to Representative Brad Sherman in September 2020, Clayton discussed the need for "good corporate hygiene" in connection with Rule 10b5-1 plans. Although well designed and administered 10b5-1 plans that eliminate "any suggestion of impropriety or unfairness" can advance good corporate governance, he said, some practices, even where legal, can "raise questions of interest alignment and fairness," especially issues surrounding trading/absence of trading in the context of plan implementation, amendment or termination. Clayton contended that inclusion in 10b5-1 plans of "mandatory seasoning"—waiting or "cooling-off" periods of perhaps four or six months—after adoption, amendment, suspension or termination and before trading can begin or resume is appropriate, demonstrates good faith and bolsters investor confidence in management and the markets. (See this PubCo post.)
- Limitations on cancellation. As noted above, insiders can cancel a 10b5-1 plan even if they do have MNPI that could influence the decision to cancel. That, to Gensler, "seems upside-down" because cancellation could be "as economically significant as carrying out an actual transaction." Accordingly, Gensler has asked the staff to consider limitations on when and how plans can be canceled.
- Mandatory disclosure. Gensler advocates mandating "disclosure regarding the adoption, modification, and terms of Rule 10b5-1 plans by individuals and companies."
- Limits on number of plans. Because insiders can enter into and cancel multiple plans, "insiders might mistakenly think they have a 'free option' to pick amongst favorable plans as they please." As a result, the staff will consider imposing limits on the number of 10b5-1 plans an individual can adopt.
- Other potential reforms. Gensler mentioned that the staff was also asked to consider other potential reforms, noting only the use of 10b5-1 plans by companies to conduct share buybacks.
Questions about use of 10b5-1 plans are not limited to plans adopted by insiders. Companies also frequently adopt 10b5-1 plans in connection with their stock repurchase programs, and these plans can also attract attention. For example, in October, the SEC settled charges against Andeavor, an energy company formerly traded on the NYSE and now wholly owned by Marathon Petroleum, in connection with stock repurchases authorized by its board in 2015 and 2016. Pursuant to that authorization, in 2018, Andeavor's CEO directed the legal department to establish a Rule 10b5-1 plan to repurchase company shares worth $250 million. At the time, however, the company's CEO was on the verge of meeting with the CEO of Marathon Petroleum to resume previously stalled negotiations on an acquisition of Andeavor at a substantial premium. Of course, a 10b5-1 plan typically doesn't work to protect against insider trading charges if you have MNPI when you establish the plan, and the SEC's order highlights facts that, from the SEC's perspective, make the information appear material—at least in hindsight. Although the SEC did not charge the company with trading on the basis of MNPI as a result of a debatably defective 10b5-1 plan, it did settle the case on charges of inadequate internal controls, charging that, when the company's legal department approved the 10b5-1 plan, it did not have sufficient information to make a judgment about MNPI. That was because the company's "informal process did not require conferring with persons reasonably likely to have potentially material information regarding significant corporate developments prior to approval of share repurchases." (See this PubCo post.)
Gensler emphasized that, although rule changes may take some time to implement, under the current rule, "cancelling or amending any 10b5-1 plans calls into question whether they were entered into in good faith. If insiders don't act in good faith when using 10b5-1 plans, those plans will not offer them an affirmative defense."
While some companies have already adopted some of these limitations as best practices, Gensler believes that mandating these changes would enhance investor confidence in the markets, which "helps both investors and businesses seeking to raise capital, grow, and innovate."
Activity under Rule 10b5-1 plans has actually long been suspect. Initially, academic studies uncovered a statistical link between the timing of executive sales under Rule 10b5-1 plans and negative corporate news, finding that executives using 10b5-1 plans generated significantly better returns than other executives at the same company. SEC Enforcement took note, signaling that sales under 10b5-1 plans would then be under scrutiny. 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).
In connection with a subsequent widely reported scandal and fraud charges by SEC Enforcement involving a 10b5-1 plan, the SEC indicated that it would be looking at improper disclosure, excessive exercise of discretion and the appearance of unusually favorable dates for purchase or sale transactions. A few years later, a study conducted by the WSJ seemed to indicate fortuitous results from trading by insiders under 10b5-1 plans that appeared to be more than serendipitous. 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.) These have become familiar themes.
In 2013, largely in response to the WSJ study, the Council of Institutional Investors filed a rulemaking petition with the SEC regarding Rule 10b5-1. Specifically, the petition requested that the SEC "consider pursuing interpretative guidance or amendments to Rule 10b5-1 that would require Rule 10b5-1 plans to adopt the following protocols and guidelines:
- "Companies and company insiders should only be permitted to adopt Rule 10b5-1 trading plans when they are permitted to buy or sell securities during company-adopted trading windows, which typically open after the announcement of the financial results from a recently completed fiscal quarter and close prior to the close of the next fiscal quarter;
- Companies and company insiders should be prohibited from adopting multiple, overlapping Rule 10b5-1 plans;
- Rule 10b5-1 plans should be subject to a mandatory delay, preferably of three months or more, between the adoption of a Rule 10b5-1 plan and the execution of the first trade pursuant to such a plan; and
- Companies and company insiders should not be allowed to make frequent modifications or cancellations of Rule 10b5-1 plans."
No action to amend the Rule was taken by the SEC at the time. (See this Cooley News Brief.)
H.R. 624, the "Promoting Transparent Standards for Corporate Insiders Act," introduced in 2019, captures some of the concepts in the CII petition, potentially requiring some significant tweaks to Rule 10b5-1 plans and disclosure about them. The legislation would have required the SEC to conduct a study of whether specified amendments to the rules governing 10b5-1 plans should be adopted, report back within a year and then adopt rule amendments consistent with the findings of the study. Introduced by the Committee Chair and co-sponsored by the Ranking Republican on the Committee, the bill passed the House in 2019, but did not move out of Committee in the Senate. It was, however, one of the bills discussed in a November 2020 Committee hearing. (See this PubCo post.)
[Below is based on my notes, so standard caveats apply.]
Interview. In an interview segment, Gensler also addressed a number of other topics.
- Climate disclosure rules. Gensler was asked whether he was leaning toward principles-based or prescriptive rulemaking and whether it would be mandatory? (See, e.g., this PubCo post.) Gensler replied that there were economic trade-offs involved in mandating the type of consistent, comparable and reliable disclosure regarding both physical and transition risks that he believes investors are seeking, and that he expected to see a balance. He was later asked whether the SEC would standardize ESG disclosure requirements with European and other global disclosure requirements. He said that, in developing a proposal, he expected the SEC to learn from work performed globally and by independent standard-setters, as well as to take public comments into account. (But see this PubCo post.) The proposal would then be subject to a notice-and-comment process. He viewed a proposal on climate disclosure, as well as a more detailed mandate on human capital disclosure, to be high priorities. He hoped to see requirements for "decision-useful" information that can be relied on. (Note the emphasis on "reliability"—does that imply an audit or attestation requirement?)
- Removal of PCAOB Chair. Gensler thanked the interviewer for her question about the reason for the dismissal of the PCAOB chair. (Really?) First, he noted that the SEC has the authority to remove the chair from this at-will position. Then, he observed that the PCAOB plays an integral role in the audit process and that he didn't think that it was living up to its potential as a standard-setter or in its enforcement role. By disbanding its investor advisory committee, the PCAOB was also not being sensitive to the needs of investors. The SEC has a comparable committee and he viewed it as important to hear the committee's views. With new members, Gensler hoped to reinvigorate the PCAOB. So was he saying that the PCAOB was too soft on auditors? He responded that reliability of the financial statements is important to companies and to the investing public. Ensuring reliability and integrity of audits through PCAOB oversight helps to ensure the integrity of the capital markets. Sorry, nothing much to dish here. (See this PubCo post.)
- More aggressive enforcement. Gensler was asked whether, given his reputation as a tough watchdog at the CFTC, SEC Enforcement would play a more aggressive role? He responded that Enforcement plays a critical role for the entire capital markets system and that Enforcement would bring cases where companies and individuals have crossed the line. (He advised CFOs who might be asking advisers and counsel whether a particular action might be over the line to step back and away from the line.) The public, he said, needs to be able to rely on the capital markets, and, to the extent that Enforcement can help to lower the incidence of fraud and manipulation in the markets, that helps the markets function better, it's better for investors and it promotes better returns for working families and companies.
- SPACs. Here, Gensler expressed concern about whether there is a level playing field for retail investors with regard to cost, disclosure and other matters. For example, do retail investors receive the same disclosure as PIPE investors? Where there is a new technology or approach, the SEC needs to be neutral but seek to ensure that investors are getting the best, most appropriate disclosure at all stages of the transaction and are protected against fraud to the extent possible. Our capital markets, he said, rest on an effective disclosure regime. He dodged the question of when any new rules regarding SPACs would be proposed—the SEC has a robust agenda and the staff is stretched with the boom in SPACs as well as in traditional IPOs, he said.
In testimony before the Subcommittee on Financial Services and General Government of the House Appropriations Committee, Gensler observed that SPACs may actually be less efficient than traditional IPOs. Gensler cited a recent study showing that "SPAC sponsors generate significant dilution and costs. SPAC sponsors generally receive 20 percent of shares as a 'promote.' The first-stage investors can redeem when they find the target, leaving the non-redeeming and later investors to bear the brunt of that dilution. In addition, financial advisors are paid fees for the first-stage blank-check IPO, for the PIPEs, and for the merger with the target. Further, it's often the case that the investors in these PIPEs are buying at a discount to a post-target IPO price. It may be that the retail public is bearing much of these costs." He said that he has "asked staff to consider what recommendations they would make to the Commission for possible rules or guidance in this area. Our Corporation Finance, Examinations, and Enforcement Division staffs will also be closely looking at each stage to ensure that investors are being protected. Each new issuer that enters the public markets presents a potential risk for fraud or other violations." (See this PubCo post.)
- Social media/gamification. Fraudulent activity used to be conducted on paper, he said, then on the internet and now on social media. The SEC will use its resources to stamp out fraud that is promoted on new technologies. He has also asked the staff to look at gamification and market structure. With regard to gamification, many of us are now tethered to our cell phones—the question is how do behavioral prompts lead us to engage in more activity? Studies show that the returns of day traders are lower than others. With regard to market structure, the staff will be looking at payment for order flow and whether there is an inherent conflict with best execution.
- Corporate governance. Gensler was asked what weak points he would identify in corporate governance. Given that much of corporate governance is not within the SEC's remit, he mentioned 10b5-1 plans and oversight of risks in accounting and appropriate disclosure for investors.
- Other. Gensler also noted, in response to a question, that the staff was continuing to look at current disclosure, such as non-GAAP finanacial measures. Asked about the LIBOR transition, he observed that there was a move away from LIBOR as a reference rate when it was discovered that it was subject to manipulation after the LIBOR rigging scandals. He said there was still a need to coalesce around a new reference rate. (See, e.g., this PubCo post and this PubCo post.)
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