Insider trading restrictions can be a constant headache for companies and their executive officers. Executives who receive a significant portion of their compensation in the form of options, restricted stock, or stock grants have a continual need to sell stock. Yet Securities and Exchange Commission’s (SEC) regulations, company insider trading policies, and fears of allegations of insider trading keep many executives from properly diversifying their holdings. As briefly discussed in our recent blog post on insider training, 10b5-1 trading plans are an ideal solution to this problem. The plan gives executives the flexibility to sell stock without regard to limitations imposed by a company’s insider trading policies, while still complying with SEC regulations. The structured nature of these plans provides an affirmative defense to allegations of insider trading, while helping to limit misinterpretations by investors.
Given the SEC’s increased focus on insider trading by executives, and the complicated determinations needed to decide if an executive or director has material non-public information (MNPI), it is anticipated that the use of 10b5-1 plans will continue to grow. Since the adoption of Rule 10b5-1 in 2000, the number of plans has grown steadily, with more than 50 percent of S&P 500 companies having executives who utilize 10b5-1 plans.
What is Rule 10b5-1?
Rule 10b5-1, established by the SEC, prohibits the purchase or sale of a security on the basis of MNPI. It is a clarification of Rule 10b-5, created under the Securities and Exchange Act of 1934, which is the primary vehicle for investigation of securities fraud. Although the rule creates more liability by prohibiting trades made while someone is merely “aware” of MNPI (rather than “using” such information), the rule also provides the affirmative defense of a 10b5‐1 plan, which is available to any person or entity.
What is a 10b5-1 plan?
Under Rule 10b5-1, large stockholders, directors, officers, and other insiders who regularly possess MNPI, but who nonetheless wish to buy or sell stock, may establish an affirmative defense to an illegal insider trading charge by adopting a written plan to buy or sell at a time when they are not in possession of MNPI. Under such plans, insider buying and selling are limited to predetermined shares at scheduled times, so that information possessed by insiders is less of an influence on their decision to trade. The plan must:
- Specify the amount, price (which may include a limit price), and specific dates of purchases or sales; or
- Include a formula or similar method for determining amount, price, and date; or
- Give the broker the exclusive right to determine whether, how, and when to make purchases and sales, as long as the broker does so without being aware of MNPI at the time the trades are made.
The protections of Rule 10b5-1 are not limited to publicly traded stocks. Private equity funds and other investment managers can benefit from Rule 10b5-1, such as by using a 10b5-1 plan to make future acquisitions or dispositions of company equity or debt without violating insider trading restrictions. Distressed debt investors also may use 10b5-1 plans to make future acquisitions or dispositions of company debt.
Benefits of 10b5-1 Plans
The most important benefit of these plans is that a properly structured plan provides affirmative defense for companies and those presumed to be insiders transacting in the relevant company’s securities. Other benefits include:
- Greater certainty to insiders in planning securities transactions;
- Potentially more opportunities for insiders to sell their shares, especially if the issuer’s trading policy permits trading under a plan during a trading or earnings blackout period;
- Potentially less negative publicity associated with insider sales; and
- Decreased burden on counsel or trading compliance officers who otherwise would have to make subjective determinations about the availability or possession of MNPI each time an insider seeks to buy or sell shares.
Who can establish a 10b5‐1 plan?
Any person or entity can establish a 10b5‐1 plan to sell or buy securities at a time when the person is not aware of MNPI, so long as the plan is not part of a scheme to evade the insider trading prohibitions of the rule. For example:
- An executive who receives a significant portion of his compensation in stock options may set up a 10b5‐1 plan to diversify his holdings
- An executive who needs liquidity to pay for the college expenses of her children might set up a 10b5‐1 plan to sell stock several weeks before each tuition payment is due
- A director may establish a 10b5‐1 plan to purchase issuer shares to satisfy stock ownership guidelines
- Any entity that may be an affiliate of the issuer or that may become privy to MNPI
- A corporation interested in buying back its stock may set up a 10b5‐1 plan to repurchase its shares at certain prices
Practice varies as to whether companies permit, encourage, or require the use of 10b5-1 plans. Properly designed and implemented plans are at least as prudent as discretionary trading under normal insider trading policies. When handled correctly, 10b5-1 plans can be an effective way to deal with the misinterpretations by investors that are often posed by insider selling.
Should a 10b5‐1 plan be publicly announced?
There is no requirement to publicly disclose the adoption, amendment, or termination of a 10b5-1 plan, although in some cases, public announcement may be advisable due to the identity of the insider, the magnitude of the plan, or other special factors. With that said, announcing the adoption of a 10b5-1 plan may be a useful way to head off future public relations issues since such an announcement prepares the market and should help investors understand the reasons for insider sales when trades are later reported. Because Rule 10b5-1 does not obviate the need for insiders to file Forms 4 and 144, the market will often quickly learn of the 10b5-1 plan once trading commences. If a company decides to announce the adoption of a 10b5-1 plan, it is recommended to not disclose plan details, other than, perhaps, the aggregate number of shares involved; this is to diminish the ability of market professionals to front-run the insider’s transactions. A company can choose whether to announce the existence of a 10b5‐1 plan by a press release followed by a Form 8‐K or solely by a Form 8‐K.
Nonetheless, 10b5-1 trading plans have been a source of controversy ever since the SEC adopted the rule in 2000, and they continue to be heavily litigated. In December, two senators called on the SEC and the Department of Justice to investigate Intel’s CEO, Brian Krzanich, for selling stock under a 10b5-1 plan shortly before the company announced a serious flaw in its processing chip. E-Trade, Lululemon, and Cigna Corporation have also each faced shareholder lawsuits for sales made under 10b5-1 plans. Shareholders also brought a suit against CBS for stock sales its executives made under 10b5-1 plans shortly before public disclosure of sexual-harassment allegations against the company’s then-chairman and CEO, Leslie Moonves.
To avoid the appearance that insiders are engaging in abusive practices, it is important for companies to establish best practices when implementing a 10b5-1 plan, such as requiring company approval of any 10b5‐1 plan, imposing a mandatory waiting period, considering minimum and maximum terms for plans, and disallowing any modification, termination, or suspension other than during open trading windows. In addition, companies should develop robust training programs regarding its insider trading and disclosure policies and the use of a 10b5‐1 plan. They should also consider periodic reviews of insiders’ trading plans to ensure compliance with the securities laws and company policies.
In summary, the 10b5-1 plan offers a straightforward way for executives to manage their shares while retaining an affirmative defense against insider trading. With proper communication among the participant, broker, and issuer, the plan can be a tool that enables insiders to diversify their investment opportunities without being circumscribed by restricted trading windows or threats of liability, while mitigating incorrect interpretations by the investment community.
Looking for guidance with your company’s 10b5-1 plan? Contact our team today.
Audrey Gibson, Analyst