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A Fresh Take

Insights on M&A, litigation, and corporate governance in the US.

| 7 minutes read

Memo to the commissioners: Improving Rule 10b5-1 without wrecking it

Published August 2, 2021 by Reuters. Re-posted with permission.

Twenty years ago, the Securities & Exchange Commission created Rule 10b5-1. Among other things, the new regulation enabled public companies, and their executives, to establish stock-trading plans. These plans enabled executives to sell their shares in their company on a regular basis without being accused of insider trading. Similarly, companies could engage in stock repurchases without running afoul of trading restrictions.

As we see it, the Rule has had a positive impact on the business community and on legal compliance in three respects. First, the Rule encouraged systematic, rather than ad hoc, trading decisions by corporate executives, thereby reducing risk that they were trading on non-public information. Second, the plans enabled employees to maintain diversification plans over a long term without having them disrupted by closure of trading windows in light of internal developments at the company. Finally, the existence of Rule 10b5-1 protected companies in meritless shareholder lawsuits by removing executives' programmed stock sales as proof of improper motive.

That is not to say that the Rule is without its critics. Some financial journalists and academics have opined that data suggests that some executives are enjoying such gains on their stock plans that they must be cheating or gaming the disclosure system. For example, some have complained that the existence of a 10b5-1 plan can cause an executive to postpone disclosing negative news about the company until after impending programmed trades have taken place.

In a June 7 statement at The Wall Street Journal's CFO Network event, SEC Chairman Gary Gensler said that he wants the Commission to "freshen up" the Rule. A related item is now on the SEC agenda for later this year.

We are not convinced that Rule 10b5-1 is broken and needs to be fixed. Nevertheless, we lay out here some options that the Commission may consider. Pending potential amendment of the regulation, some of these options are items that companies may wish to implement on their own as part of corporate good housekeeping.

Critics have voiced three concerns about Rule 10b5-1 in practice. First, some reporters have suggested that companies sometimes time their public disclosures so as to maximize their executives' gain on upcoming programmed trades.

Second, some are concerned that, where a plan ties particular levels of sales to achievement of a given price target on the stock, awareness of that target may incentivize an executive to drive the stock price to that level, even if she needs to engage in unsound practices to do so.

Third, others have commented that executives appear to be gaming the system by suspending or terminating their trading plans in order to time market movements in the stock or trends in the company's financial performance.

These concerns need to be balanced against the positive impact that programmed trading plans have had in reducing pressure on GCs to clear one-off trades and limiting panicked sales based on nonpublic information.

The changes in the Rule that the SEC might consider fall into three buckets: transparency; simplicity; and accountability.

A fair criticism of the current process is that the trading public knows quite little about the trading plans. Typically, when an executive who is required to report her trades does so on Form 4, the filing will state that the trade was made pursuant to a 10b5-1 plan. Nothing more.

There are a range of measures with respect to transparency that the Commission may consider. For example, the regulation might require a company to disclose in a timely manner (perhaps on Form 8-K) events involving 10b5-1 plans by its directors or officers. This could include the adoption, modification, suspension, or termination of any plan. Presumably the disclosure would include the dates of commencement and termination. One can debate whether the disclosure should also include the number of shares subject to the plan.

A more controversial point will be whether the requirement should include the "formula" of the plan: i.e., the number of shares to be sold at what price levels (in our view, that requirement could end 10b5-1 plans altogether, because executives would probably forgo the plans rather than lay out their views as to disposition at particular trading prices).

A second possible transparency feature would be to require the company to file confidentially with the SEC each of its executives' 10b5-1 plans. The plans could be exempt from public disclosure. But to the extent that a particular person was thinking about gaming the system, knowledge that the SEC staff could be viewing their plan might discourage untoward actions.

After the plan expires, the Commission might require, on a periodic basis, disclosure of what happened under the plan: which trades, with dates and number of shares, and any deviation/suspension from the original plan. Again, knowing that this disclosure would be coming might curb any inappropriate trading behavior.

For years, both of us have advised clients that, when it comes to 10b5-1 plans, simplicity is a cardinal virtue. So, some of the tweaks we discuss now may be worth corporate counsel considering, with or without regulatory amendments.

The first consideration in crafting any 10b5-1 plan is the waiting period — the elapsed time between adoption and implementation. Commentators have focused on the rapidity with which trades begin after a plan has been adopted. The fundamental premise of the current rule is that, at the time an executive adopts the plan, she does not have any material nonpublic information, especially about the company's near-term prospects.

The Commission may choose to adopt rules that impose timing constraints, such as by requiring that plans be adopted only during an open window under the company's insider trading policy and prohibiting trades pursuant to a plan until after announcement of results for the quarter in which it was adopted (but at least some minimum number of days after adoption). The Commission could go even farther and say that the waiting period should include a complete fiscal quarter plus the announcement thereof before any trades can begin.

The Commission may also address the suspension or termination of plans. The Commission might require that, if an executive terminates her plan, she may not adopt a new plan until a full intervening quarter has elapsed. Similarly, if someone suspends a plan, the SEC might provide that the plan may not be recommenced until after the company has announced the results of the current quarter.

The Commission could also require that a plan cover a minimum length of time (such as six months), place a limit on the number of plans that may be adopted by an executive in one year (such as two), and eliminate the ability of an executive to have more than one plan at a time. These limitations prohibit an executive from adopting multiple short-term plans or overlapping plans that may take advantage of nonpublic information (or the perception thereof). But rigid requirements should be balanced against valid financial planning considerations. The longer the required plan term, the greater the chance that an executive will have a legitimate need to modify or terminate a plan for financial planning purposes.

The Commission could also prohibit someone who has adopted a 10b5-1 plan from disposing of any shares in the company outside the plan during its term. In other words, one can't mix plan sales and ad hoc sales. As a practical matter, most brokers prohibit ad hoc sales in their clients' 10b5-1 plans because it makes it difficult for the broker to calculate volume limits. Also, if an executive currently makes non-plan sales while a plan is also in place, she is likely to face pejorative allegations in any shareholder suit about that period.

For those suspicious of trades under a 10b5-1 plan, transparency and simplicity alone may not be enough. They will seek accountability. The SEC might consider three options in this regard.

First, the regulation might require higher-level approval of the plans than commonly occurs. Typically, the internal compliance officer (usually someone in Legal) must sign off on a plan. This approval might be escalated to the level of a board committee once the compliance officer has registered no objection. Such board involvement in some instances might trigger useful dialogue between the board and a senior executive about her perceptions and plans regarding the company. This must be weighed against the additional administrative burden on the board.

Second, a board committee might be required to approve any modification, suspension, or termination of an existing plan. Those who counsel public companies would probably agree that these actions often present thornier issues than a simple adoption. The board might require the executive to set out her reasons for the action. For those suspicious of conduct under the plans, board review might provide a disinfecting light.

Finally, the SEC may consider making Rule 10b5-1 unavailable to an executive who has modified, suspended or terminated more than one plan. The perceived risk of 10b5-1 may be with persons who stop, start and change their plans frequently. Imposing a "two strikes" rule on future plans could incentivize executives to keep it simple and stable.

Many companies, particularly in the tech sector, engage in frequent stock repurchases in lieu of paying dividends. They have tended to do so through plans that are designed to comply with both Rule 10b5-1 and Rule 10b-18, which is a safe harbor from market manipulation rules for qualifying stock repurchases. The Commission is likely to evaluate these plans along with individual plans.

The duration of corporate plans is often quarter-to-quarter. The plans are sometimes adopted with minimal delay between approval and execution. Although corporate repurchases have seldom been the focus of regulatory action or private suits, the SEC may wish to provide refined guidance as to how such plans should operate.

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Our goal here has been to highlight some of the facets of 10b5-1 plans that might be the subject of SEC deliberation. We are not endorsing any particular features; in fact, we disagree with some of them. Nevertheless, the business community should be part of the "freshening up" process lest they find at the conclusion of it that political pressures have made the 10b5-1 option less useful to them and their executives.


capital markets and securities