No April Fool’s Joke

The SEC promulgated Rule 10b5-1 in October 2000 to resolve an unsettled issue over the definition of insider trading which is prohibited by SEC Rule 10b-5. By way of background, the SEC adopted Rule 10b5-1 to permit corporate insiders, who regularly possess material non-public information (MNPI), to sell their company shares without the risk of claims of insider trading. Pursuant to the Rule 10b5-1 safe harbor, a corporate insider can establish a trading plan specifying pre-established dates for determining when the insider can sell shares without the risk of insider trading. To be valid, the plan must, among other things, be executed while the insider is not in possession of MNPI and be implemented in good faith. If such a plan is validly established, an insider who subsequently transacts pursuant to that plan is permitted an affirmative defense to insider trading allegations.

A trio of 2021 events shined a spotlight on SEC Rule 10b5-1 plans:

• On January 19, 2021, a Stanford University published a study, titled “Gaming the System; Three ‘Red Flags’ of Potential 10b5-1 Abuse,” in which the authors presented “new evidence” on the trading behavior of corporate executives using a unique dataset of over 20,000 10b5-1 plans. The study showed “that a subset of executives use 10b5-1 plans to engage in opportunistic, large-scale selling of company shares.”
• On June 7, 2021, in remarks before the Wall Street Journal’s CFO Network Summit, SEC Chair Gary Gensler identified plans to “freshen up” Rule 10b5-1 in response to “cracks in our insider trading regime”—citing the Stanford study—and outlined several areas of focus for the SEC regarding executive stock ownership and the means by which insiders sell shares in the companies with which they’re affiliated while in possession of material information that the public doesn’t have.
• On June 24, 2021, U.S. Senators Chris Van Hollen and Deb Fischer reintroduced their bipartisan Promoting Transparent Standards for Corporate Insiders Act to bring greater transparency to corporate stock trading. If enacted, the bipartisan bill would require the SEC to study the issue of insider trading, report their findings to Congress, and write additional rules restricting an insider’s ability to take advantage of the system.

In particular, the Stanford study’s authors focused on three “red flags” associated with the opportunistic use of 10b5-1 plans: (1) short cooling-off periods, (2) plans that cover a single block trade, and (3) plans that are adopted and commence trading immediately before earnings announcements. Chairman Gensler identified these same aspects, as well as enhanced disclosure requirements, as areas of potential reform for Rule 10b5-1.

The SEC has now strengthened investor protections by helping investors understand when and how insiders are trading in securities for which they may have MNPI by amending SEC Rule 10b5-1. In particular, the amendments:

• Add a condition that all persons entering into a Rule 10b5-1 plan must act in good faith with respect to the plan;
• Adopt a cooling-off period for persons other than issuers before trading can commence under a Rule 10b5-1 plan;
• Provide that directors and officers must include representations in their plans certifying at the time of the adoption of a new or modified Rule 10b5-1 plan that: (1) they are not aware of any MNPI about the issuer or its securities; and (2) they are adopting the plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5;
• Restrict the use of multiple overlapping trading plans and limits the ability to rely on the affirmative defense for a single-trade plan to one single-trade plan per twelve-month period for all persons other than issuers;
• Require more comprehensive disclosure about issuers’ policies and procedures related to insider trading, including quarterly disclosure by issuers regarding the use of Rule 10b5-1 plans and certain other trading arrangements by its directors and officers for the trading of its securities; and
• Require disclosure of issuers’ policies and practices around the timing of options grants and the release of material nonpublic information.

As Chairman Gensler noted, these issues “speak to the confidence that investors have in the market” and “[a]nytime we can increase investor confidence in the markets, that’s a good thing.”

The final rule adopted by the SEC becomes effective on April 1, 2023.