SEC amends Rule 10b5-1 and adopts disclosures related to insider trading

The SEC has amended Rule 10b5-1 of the Securities Exchange Act of 1934 (Exchange Act) and adopted new disclosure requirements related to trading by public company insiders.

The amendments and disclosure rules, adopted on December 14, 2022, become effective on February 27, 2023, require issuers to make certain disclosures in periodic reports and proxy or information statements starting with the filing that covers the first full fiscal period beginning on or after April 1, 2023, and require Section 16 reporting persons to make certain disclosures in beneficial ownership reports filed on or after April 1, 2023.

Given the heightened interest of both the SEC and the Department of Justice in investigating and prosecuting insider trading and potential abuses of Rule 10b5-1, public companies may wish to consider if revisions to policies and procedures are appropriate and whether their insider trading policies and procedures are reasonably designed to detect and prevent violations of laws prohibiting insider trading. 

Background

Adopted in August 2000, Rule 10b5-1 provides an affirmative defense to insider trading liability under Section 10(b) and Rule 10b-5 of the Exchange Act for insiders of publicly traded corporations who buy and sell company securities pursuant to pre-determined trading plans, commonly known as 10b5-1 Plans. To qualify for the affirmative defense, the insider, among other items, had to establish the 10b5-1 Plan in good faith and while not in possession of material nonpublic information, or MNPI.  If an insider became aware of MNPI after buying or selling company securities, the insider could defend against insider trading allegations by showing that the trades were made in accordance with a 10b5-1 Plan that satisfied the conditions of the rule.   

Although Rule 10b5-1 was enacted to provide protection to insiders who trade ethically, courts, commentators, and Congress expressed concern that insiders were using Rule 10b5-1 to trade opportunistically based on MNPI.  Some academic studies supported these concerns through analyses suggesting that trading under 10b5-1 Plans consistently and significantly outperformed trading outside of such plans.

The amendments to Rule 10b5-1 and the new disclosure rules are intended to prevent the abuse of insider trading plans by public companies, directors, and officers and to provide investors with more information regarding the steps taken by public companies to prevent insider trading.  In adopting the new rules, the SEC stated that it expects the amendments and disclosure rules to help prevent opportunistic trading by insiders, increase investor confidence, enable more informed investment and voting decisions, and ultimately result in enhanced liquidity and capital formation. 

THE AMENDMENTS TO RULE 10b5-1

The amendments to Rule 10b5-1 establish the following new conditions to the availability of the affirmative defense offered by the rule: 

Cooling off periods:  Previously, Rule 10b5-1(c) did not impose any mandatory cooling off periods between the creation of the 10b5-1 Plan and the first trade, although many public companies and brokers administering 10b5-1 Plans required one as a matter of policy or practice.  The amendment imposes the following mandatory cooling off periods between the adoption or modification of a 10b5-1 Plan and the date of the first trade:

Directors and officers (as defined in Exchange Act Rule 16a-1(f)):  the later of (i) 90 days after adoption of or certain modifications to the 10b5-1 Plan or (ii) two business days after disclosure of the issuer’s financial results in a Form 10-Q or Form 10-K for the quarter in which the 10b5-1 Plan was adopted (or if a foreign private issuer, Form 20-F or a Form 6-K that discloses the issuer’s final results).  The cooling off period is subject to a maximum of 120 days after adoption of the 10b5-1 Plan.

Non-directors and non-officers:  30 days after adoption of certain modifications to the 10b5-1 Plan.

Citing comment letters to its proposed rule change by DLA Piper and others, the SEC’s final rules modified its proposed rules to provide for a shorter cooling off period than the SEC’s original proposed 120-day cooling off period for officers and directors.

Only modifications or changes to the amount, price or timing of the purchase or sale of securities (or modifications/changes to a formula, algorithm or computer program that affect those terms) under a 10b5-1 Plan trigger a new cooling off period.

In a departure from the proposed rules, which included a 30-day issuer cooling off period for issuers repurchasing securities under Rule 10b5-1, there is no mandatory cooling off period for issuer repurchase plans structured to rely on Rule 10b5-1.

Director and officer certifications: To receive the benefit the of the affirmative defense, directors and officers now must certify when adopting or modifying a 10b5-1 Plan that (i) they are not aware of MNPI regarding the issuer or its securities, and (ii) they are adopting the trading plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5. The SEC has emphasized that whether directors and officers can make these certifications is an intensive fact-specific analysis, and that directors and officers can consult with legal counsel to determine whether they can make the certifications truthfully, subject to confidentiality obligations. 

Good faith condition:  The affirmative defense is only available if a 10b5-1 Plan was entered into in good faith and not as part of a plan or scheme to evade the prohibitions of the rule.  To address concerns that corporate insiders may take actions after adopting a 10b5-1 Plan in order to benefit from MNPI, the amendments impose an additional good faith condition requiring the adopter of a 10b5-1 Plan to act in good faith throughout the duration of the plan and not just at its adoption. 

Restriction of overlapping plans:  To address concerns that insiders were adopting multiple overlapping 10b5-1 Plans to exploit MNPI, the amendments restrict the adoption and use of multiple overlapping plans by anyone other than the issuer.  The restriction does not, however, apply to individuals transacting directly with a company (eg, participation in employee stock ownership plans).

More specifically, to rely on the affirmative defense, insiders generally may not have another outstanding (and may not subsequently enter into any additional) plan that would qualify for the affirmative defense. The restriction also applies to single trade plans (meaning plans to affect the purchase or sale of the total amount of securities in a single transaction where the agent’s future trades do not depend on events or data unknown at the time the plan is entered into, and it is not reasonably foreseeable that the plan might result in multiple transactions when the plan is entered into). There are, however, certain exceptions to this restriction, including:

Trades with different broker-dealers under a single “plan”:  Insiders may use multiple brokers, through a series of separate contracts with different broker-dealers or agents acting on behalf of the insider (other than the issuer), to execute trades under a single 10b5-1 Plan that covers securities held in different accounts.  Each contract, when taken together as a whole, must meet all of the requirements of and remain subject to the provisions of the rule.  A modification of one plan will be treated as a modification of the other contracts that are part of the single plan.

Consecutive 10b5-1 Plans:  An insider may maintain two separate plans at the same time so long as trading under the later-commencing plan is not authorized to begin until after all trades under the first plan are completed or expired.  This exception is not available if the first trade under the second plan is scheduled to occur during the cooling off period that would be applicable to the second plan had it been adopted on the date the first plan terminated.

“Sell-to-cover” transactions:  Insiders will not lose the benefit of the affirmative defense if they have another plan provided that the second plan only authorizes qualified sell-to-cover transactions that instruct the insider’s agents to sell securities in order to satisfy tax withholding obligations at the time an award vests.

NEW DISCLOSURE REQUIREMENTS

The SEC also adopted certain new disclosure requirements designed to increase transparency for investors regarding the use of 10b5-1 Plans or other trading arrangements, issuer insider trading policies and procedures, and issuer option grant practices:

Quarterly reporting of 10b5-1 Plans: Registrants are now required to: (i) disclose whether, during the registrant’s last fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report), any director or officer adopted or terminated (a) a 10b5-1 Plan and/or (b) any written trading arrangement that meets the requirements of a non-Rule 10b5-1 trading arrangement (Non-10b5-1 Plan) as defined in Item 408(c) of Regulation S-K; and (ii) provide a description of the material terms of such 10b5-1 Plan or Non-10b5-1 Plan.  The description of the material terms of these plans excludes terms with respect to the price at which the trader is authorized to trade, but includes the name and title of the insider, date of adoption or termination of the plan, duration of the plan, and aggregate number of securities to be sold or purchased under the plan.

In addition, any modification to a 10b5-1 Plan or any Non-10b5-1 Plan that includes a change to the amount, price, or timing of the purchase or sale of securities or a substitution or removal of a broker executing trades under the plan must be disclosed.  Such changes are considered a termination of a plan and the adoption of a new plan. 

Disclosure of insider trading policies and procedures: Registrants are now required to disclose whether they have adopted insider trading policies and procedures governing the purchase, sale, and other dispositions of their securities by directors, officers, and employees, or the registrant itself that are reasonably designed to promote compliance with insider trading laws, rules, and regulations, and any listing standards applicable to the registrant.  If a registrant has not adopted insider trading policies and procedures, it must explain why.  This disclosure is required in a domestic filer’s annual reports on Form 10-K and proxy and information statements on Schedules 14A and 14C, or in a foreign private issuer’s annual report on Form 20-F.  In addition, a registrant must file a copy of its insider trading policies and procedures as an exhibit to its Form 10-K or Form 20-F.

While the SEC stated in the adopting release that it is not requiring specific provisions in insider trading policies, the SEC referenced certain provisions that it viewed as meaningful to investors, including provisions that:

• Describe how the issuer prevents the unlawful communication of and trading on the basis of MNPI
  
  
• Include a process for analyzing whether directors, officers, employees, or the issuer itself (when conducting open market share repurchases) have MNPI and a process for documenting those analyses and approving purchase or sale requests and
  
  
• Explain how the issuer enforces compliance with its policies and procedures.

Significantly, the required disclosure of insider trading policies and procedures may also serve as the basis for increased SEC enforcement activity against companies based on claimed inadequacies in those policies and procedures.  By way of example, the SEC recently sued two companies for internal control failures premised in part on alleged failures of insider trading procedures, and in one case, the SEC also alleged that the company violated Exchange Act Section 10(b) and Rule 10b-5.  Companies with what the SEC concludes are insufficiently robust insider trading policies and procedures are particularly vulnerable to challenge as to their own transactions.  In addition, now that a company must disclose its insider trading policies and procedures, if those policies and procedures are not followed or fail to detect and prevent insider trading by a director, officer or employee, the company’s disclosure could be challenged in 20-20 hindsight as false or misleading.  Moreover, this increased focus on insider trading may foreshadow heightened SEC and plaintiffs’ lawyer scrutiny as to whether the company as a “control person” has failed to maintain a program reasonably designed to detect and prevent insider trading violations by its directors, officers and employees.

Disclosure of option grants close in time to the release of MNPI: Registrants must now provide both narrative and tabular disclosures with respect to option grants and other similar equity instruments close in time to the release of MNPI to the public.

Registrants are now required to discuss their policies and practices on the timing of awards of stock options, SARs and/or similar option-like instruments in relation to the disclosure of MNPI by the registrant.  The narrative disclosure should include how the registrant’s board determines when to grant awards (eg, a predetermined schedule), whether the board or a compensation committee takes MNPI into account when determining the terms of an award, and whether the registrant has timed the disclosure of MNPI to affect the value of executive compensation.

Registrants must also disclose, in tabular format, any option awards, SARs and/or similar option-like instruments issued to named executive officers (NEOs) in the last completed fiscal year within a period ranging from four business days before to one business day after the filing of a periodic report on Form 10-Q or 10-K or the filing or furnishing of a current report on Form 8-K that discloses MNPI (eg, earnings information), other than a Form 8-K disclosing a material new option award grant under Item 5.02(e).  This disclosure includes, among other information: the name of the NEO; the grant date of the award; the number of securities underlying the award; and the per-share exercise price.   

10b5-1 Plan transaction and gift reporting:  Section 16 reporting persons (generally, directors, officers and 10 percent beneficial owners of a domestic public company) must now indicate by checkbox on Forms 4 and 5 that a reported transaction is intended to satisfy the affirmative defense conditions of Rule 10b5-1(c) while also disclosing the date of adoption of the relevant 10b5-1 Plan.

In addition, Section 16 reporting persons are now required to report bona fide gifts of equity securities on Form 4 (as opposed to Form 5) before the end of the second business day following the gift. 

Structured data requirements:  Registrants are now required to tag using Inline XBRL the information specified by new narrative disclosure related to their policies and practices on the timing of option awards (Regulation S-K Item 402(x)), the material terms of officer and director 10b5-1 Plans (Regulation S-K Item 408(a)), and their insider trading policies and procedures (Regulation S-K Item 408(b)(1)).    

Effectiveness

The final rules will become effective on February 27, 2023.  Section 16 reporting persons will be required to comply with the amendments to Forms 4 and 5 for beneficial ownership reports filed on or after April 1, 2023.  Issuers will be required to comply with the new disclosure requirements in Exchange Act periodic reports on Forms 10-Q, 10-K and 20-F and in any proxy or information statements in the first filing that covers the first full fiscal period that begins on or after April 1, 2023.  For issuers with a calendar-based fiscal year, the disclosure requirements will therefore begin with their Quarterly Report on Form 10-Q for the second quarter of 2023 and the 2024 proxy season.  The final amendments defer by six months the date of compliance with the additional disclosure requirements for smaller reporting companies.

Practical considerations

To prepare for the increased attention to and new disclosures concerning 10b5-1 Plans and insider trading policies and practices, including the SEC’s focus on internal controls related to insider trading, companies should consider taking the following actions:

• Review existing policies and procedures related to insider trading, 10b5-1 Plans, and issuer repurchase programs to evaluate whether any revisions or updates are needed, whether any additional policies or procedures may be necessary, including whether additional procedures are necessary for ensuring compliance with cooling off periods following the adoption or modification of a 10b5-1 Plan, and whether any clarifications or other modifications may be desirable in advance of public disclosure.
  
  
• Consider whether equity award grant practices could result in heightened scrutiny and, if so, whether any revisions to those practices are appropriate, including whether compensation committee meetings and processes need adjustment in light of the new disclosure requirements or whether additional procedures are necessary to monitor the timing of option grants (or other similar awards) compared to the timing of periodic and current reports.
  
  
• Establish disclosure controls and procedures to cover the new disclosure requirements, including any planned voluntary disclosure relating to 10b5-1 Plans, insider trading policies and procedures, and equity awards near filing deadlines, and assess whether any additional controls and related processes may be necessary or appropriate to review trading policies or activity of directors, officers and employees in light of the new disclosure requirements.
  
  
• Evaluate internal controls to assess whether they are effective in detecting and preventing potential insider trading concerns including those related to issuer transactions, such as open market purchases, tender offers, privately negotiated transactions and accelerated share repurchases.
  
  
• Provide updated training to directors, officers, and other employees on the new rules as well as on the company’s policies and procedures related to insider trading and the treatment of MNPI.

There is a short window for implementation of the Amendments and Disclosure Rules.  For more information and assistance in understanding and implementing the requirements, please contact the authors of this article or your DLA Piper relationship attorney.