Because the Rule 10b5-1(c)(1) affirmative defense is elective, insiders and companies that find the proposed conditions to be too restrictive might elect not to rely on it for their trading. 

On December 15, 2021, the Securities and Exchange Commission (SEC) proposed for public comment amendments to Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (Exchange Act), and new related disclosure requirements. The proposed amendments would, among other things, add new conditions to the availability of the affirmative defense against insider trading liability afforded by the rule and create new disclosure requirements regarding issuers’ insider trading policies, Rule 10b5-1 plans by directors, officers and issuers and equity compensation awarded in close proximity in time to certain corporate announcements. The proposed amendments are intended to limit abusive use of the affirmative defense against insider trading liability and to provide greater transparency to outside investors about the issuers and insiders’ Rule 10b5-1 plans, as well as insiders’ compensation and incentives.

Background

Section 10(b) of the Exchange Act and Rule 10b-5 adopted thereunder prohibit the purchase or sale of a security on the basis of material nonpublic information (MNPI). Rule 10b5‑1 establishes as a general rule that a purchase or sale of an issuer’s security is on the basis of MNPI about that security or its issuer if the purchaser or seller was aware of MNPI when making that purchase or sale (that is, possession of MNPI―even without its use―could be sufficient to establish insider trading liability). However, Rule 10b5-1(c)(1) also provides an affirmative defense to the general rule: A person in possession of MNPI about an issuer or its securities will not be considered to trade “on the basis” of MNPI if the trades are made under a plan that was adopted when that person was not aware of MNPI and meets other conditions of Rule 10b5-1(c)(1). This type of plan is often referred to as a “Rule 10b5-1 plan” or a “10b5-1 plan.” As discussed in detail below, the proposed amendments are intended to curb practices, considered by the SEC to be potentially abusive, associated with trading under Rule 10b5-1 plans.

Amendments

Amendments to Rule 10b5-1

Cooling-Off Period

Rule 10b5-1(c)(1) currently does not impose any waiting period between the date a Rule 10b-5 plan is adopted and the date of the first transaction to be executed under such plan. The proposed amendments mandate, as a condition to the availability of the affirmative defense under Rule 10b5-1(c), the following cooling-off periods before any trading can commence under a new or modified Rule 10b5-1 plan:

• At least 120 days after the date of adoption or modification of any Rule 10b5-1 plan by a director or officer; and
• At least 30 days after the date of adoption or modification of any Rule 10b5-1 plan by an issuer.

Even though the SEC does not prohibit an insider from trading any time the insider is not in possession of MNPI without implementing a Rule 10b5-1 plan, the SEC stated that these new cooling-off periods are intended to prevent directors, officers and issuers who might be aware of MNPI from adopting or modifying a Rule 10b5-1 plan and trading immediately thereafter pursuant to the plan, as well as discourage those persons from selectively terminating or cancelling a planned trade under a Rule 10b5-1 plan based on MNPI. Under the proposed amendments, a modification of an existing Rule 10b5-1 plan, including cancelling one or more trades under the plan, would be deemed equivalent to terminating the existing plan in its entirety and adopting a new plan, so the cooling-off period would apply after a modification before any new trades could commence under the modified plan.

Director and Officer Certifications

Currently, no certification is required as a condition to the availability of the Rule 10b5-1(c)(1) affirmative defense. Under the proposed amendments, availability of the Rule 10b5-1 affirmative defense is conditioned on the director or officer seeking to rely on it to personally certify to the issuer, on the date of adoption of the Rule 10b5-1 plan, that: (i) the director or officer is not aware of MNPI about the issuer or the security when adopting the plan; and (ii) the plan is adopted in good faith and not as part of a plan or scheme to evade the prohibitions of Section 10(b) of the Exchange Act or Rule 10b-5 thereunder. The proposed amendments do not require the director or officer, or the issuer, to file the certification with the SEC.

Although the SEC indicated that the proposed certification would not be an independent basis of liability for directors or officers under Section 10(b) of the Exchange Act and Rule 10b-5, that interpretation may not bind a court in private litigation. The proposed amendments also instruct that a director or officer seeking to rely on the affirmative defense should retain a copy of the certification for 10 years (in consideration of the statutes of limitations that govern the SEC’s ability to seek remedies for insider trading claims).

Restricting Multiple Overlapping Rule 10b5-1 Plans and Single-Trade Plans

Under current rules, a person is not entitled to the Rule 10b5-1(c)(1) affirmative defense for a trade if that person enters into or alters a “corresponding or hedging transaction or position” with respect to the planned trade. The SEC designed the requirement to prevent schemes to exploit MNPI by setting up pre-existing hedged trading programs, and then canceling execution of the unfavorable side of the hedge while permitting execution of the favorable transaction. The use of multiple plans may simulate this kind of impermissible hedging.

The proposed amendments eliminate the affirmative defense for any trade by a person who has established multiple overlapping plans for open market transactions of the same class of securities. However, the proposed amendments would not apply to transactions where a person acquires (or sells) securities directly from the issuer, such as acquiring shares through participation in employee stock ownership plans (ESOPs) or dividend reinvestment plans (DRIPs), thereby preserving the benefits of flexibility for plan participants with respect to such plans.

In addition, the proposed amendments limit the availability of the Rule 10b5-1(c)(1) affirmative defense for a plan designed to cover a single trade, so that the affirmative defense would be available for only one single-trade plan during any 12-month period. Recent research upon which the SEC relies indicates that single-trade plans are consistently loss-avoiding and often precede stock price declines, suggesting that insiders using single-trade plans may be executing trades based on MNPI. The proposed limitation on single-trade plans is intended to balance the legitimate use of single-trade plans to address one-time liquidity needs against potential for abuse.

Good Faith Requirement

Currently, the Rule 10b5-1(c)(1) affirmative defense is only available if a plan was “entered into” in good faith and not as part of a plan or scheme to evade the prohibitions of the rule. The SEC expressed concern that insiders may improperly influence the timing of public disclosures to benefit their trades under Rule 10b5-1 plans. In addition, the SEC expressed concern that a Rule 10b5-1 plan may be canceled or modified in an attempt to evade the insider trading prohibitions without affecting the availability of the affirmative defense. To address these concerns, the proposed amendments add a condition that a Rule 10b5-1 plan be “operated” in good faith, making clear that both the initial entry into the plan as well as the operation of the plan must be conducted in good faith.

Disclosures Regarding Rule 10b5-1 Plans and Other Trading Plans, and Insider Trading Policies

Currently, there is no mandatory disclosure requirement concerning the use of Rule 10b5-1 plans (or other trading plans) by companies or insiders; issuers also are not required to disclose their insider trading policies or procedures. Having expressed concern that this lack of transparency may deprive investors of the ability to assess potential incentive conflicts and information asymmetries, the SEC now proposes amendments to Forms 10-Q and 10-K and proxy and information statements on Schedules 14A and 14C that would require: (i) quarterly disclosure of the use of Rule 10b5-1 (and other non-Rule 10b5-1 trading plans) by a public company and its directors and officers for the trading of the issuer’s securities; and (ii) annual disclosure of a public company’s insider trading policies and procedures. In addition, the proposed amendments add a new disclosure item on Form 20-F to require annual disclosure of a foreign private issuer’s insider trading policies and procedures. The proposed disclosures that would be required in Forms 10-Q, 10-K and 20-F would be subject to the principal executive and principal financial officer certifications required by Section 302 of the Sarbanes-Oxley Act of 2002.

The proposed amendments also add on Section 16 filings (i) a mandatory checkbox to indicate whether a reported transaction was made pursuant to a Rule 10b5-1 plan and (ii) an optional checkbox to indicate that a reported transaction was made pursuant to a plan that did not satisfy the conditions of Rule 10b5-1(c).

Disclosure Regarding the Timing of Equity Grants Shortly Before or After the Release of MNPI

The SEC expressed concern that executives may seek to time option grants to occur immediately before the release of positive MNPI (aka spring-loading), or delay a planned option award until after the release of negative MNPI (aka bullet-dodging). Under the current disclosure rules, compensation-related equity interests are required to be presented in a tabular format and accompanied by appropriate narrative disclosure necessary for an understanding of the information presented in a table. Option grants that are spring-loading or bullet-dodging are not required to be separately identified in these tables.

The proposed amendments require public companies to disclose in a new table any option awards to named executive officers or directors that are made within 14 calendar days before or after the release of certain MNPI (including the filing of a periodic report, an issuer share repurchase or the filing or furnishing of a current report on Form 8-K that contains MNPI), together with the market prices of the underlying securities on both the trading day before and after disclosure of the MNPI. Smaller reporting companies or emerging growth companies would not be exempt from these proposed disclosures.

Reporting of Gifts on Form 4

The current rules require Section 16-reporting persons to report any bona fide gift of registered equity securities on Form 5, but permit such insiders to report them on a delayed basis. The SEC expressed concern that the length of the filing period for Form 5 may allow insiders to engage in certain practices that the SEC considered problematic involving gifts of securities, such as insiders making stock gifts while in possession of MNPI, or backdating a stock gift in order to maximize a donor’s tax benefit. To address these concerns, the proposed amendments require officers, directors or beneficial owners of more than 10 percent of the issuer’s registered equity securities making a gift of equity securities to report the gifts on Form 4 before the end of the second business day following the date of execution of the transaction. This would be significantly earlier than what is required under current rules.

Potential Consequences

Generally, the proposed amendments would narrow the conditions under which the Rule 10b5-1(c)(1) affirmative defense would be available and make Rule 10b5-1 plans more complicated for insiders and companies to use. For example, to satisfy the proposed certifications condition, directors and officers may need to consult with legal or other advisers to help analyze whether they have MNPI, or to obtain multiple levels of subcertifications by the companies or other officers to enable the trading insiders to make required certifications (similar to what we have seen with respect to existing certification requirements in the Forms 10-K and 10-Q). As another example, the new good faith requirement could result in difficulties in cancelling Rule 10b5-1 plans: The cancellation of a Rule 10b5-1 plan while an insider is in possession of MNPI may be deemed bad faith (whereas a decision not to trade outside Rule 10b5-1 plans would not be a “purchase or sale” under Section 10(b) of the Exchange Act or Rule 10b-5 thereunder). Because directors and officers often are aware of MNPI, to the extent that they perceive the proposed amendments as increasing legal risk associated with adopting, modifying or cancelling a Rule 10b5-1 plan, they may reduce their use of Rule 10b5-1 plans.

Because the Rule 10b5-1(c)(1) affirmative defense is elective, insiders and companies that find the proposed conditions to be too restrictive might elect not to rely on it for their trading. However, insiders and companies that choose not to rely on Rule 10b5-1(c)(1) may incur other costs―such as legal cost to evaluate whether trades conducted pursuant to a plan not reliant on Rule 10b5-1(c)(1) or conducted without a trading plan are compliant with the Exchange Act and SEC regulations― and increased legal liability risk, as well as the loss of the ability to schedule execution of trades during blackout periods (whereas trades under Rule 10b5-1 plans generally can be executed during blackout periods). Although the proposed amendments likely would have adverse impact on both insiders and companies, the effect of the proposed conditions on the Rule 10b5-1(c)(1) affirmative defense for companies may be less significant because they may be able to rely on an alternative affirmative defense, which is available to entities only and not to natural persons. (That affirmative defense requires that the individual making an investment decision on the entity’s behalf was not aware of MNPI, and that the entity had implemented reasonable policies and procedures to prevent insider trading.)

As the use of Rule 10b5-1 plans becomes more complicated and costly, this could decrease liquidity of the insider’s holdings of the issuer’s securities, including reduced ability to meet unanticipated liquidity needs as well as potential constraints on portfolio rebalancing and achieving optimal portfolio diversification and tax treatment. This illiquidity would in turn reduce the value of insiders’ compensation. Some insiders may seek to reduce holdings of company shares in general (through buying fewer shares, selling shares more quickly when eligible and negotiating for cash pay in lieu of equity pay), which may in turn reduce incentive alignment between insiders and stockholders. Some insiders may seek higher total pay to compensate for the illiquidity risk. The cost to issuers of potential shifts in executive compensation (whether in the form of additional compensation for insiders or changes in compensation structure that weaken insider incentives) would be borne by existing shareholders, including outsiders who are the intended primary beneficiaries of the proposed amendments.

Conclusion

The proposed amendments, if adopted, could reshape the insider trading law landscape. The potentially profound effects of the proposed amendments likely will prompt significant comment from market participants during the comment period (that is, 45 days starting from publication of the proposed amendments in the Federal Register, which will occur in the coming days). Our team will continue to monitor developments around these proposed amendments.

For More Information

If you have any questions about this Alert, please contact Darrick M. Mix, Richard A. Silfen, Phuong (Michelle) Ngo, any of the attorneys in our Corporate Practice Group, any of the attorneys in our White-Collar Criminal Defense, Corporate Investigations and Regulatory Compliance Group or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.