This month, the SEC's Investor Advisory Committee will be taking up draft subcommittee recommendations regarding two hot topics-Rule 10b5-1 plans and SPACs-both of which have now been posted. The wide berth Rule 10b5-1 gives insiders to conduct transactions under Rule 10b5-1 plans, together with the absence of public information requirements, has long fueled controversy about these plans. Potential problems with 10b5-1 plans have been recognized in many quarters-including by former SEC Chair Jay Clayton and current Chair Gary Gensler-and the IAC subcommittee believes there is "strong bipartisan support" for improvements to Rule 10b5-1 that would enhance the rule's effectiveness and "improve transparency regarding insider trades and enable effective investigation and enforcement of violations." The IAC subcommittee recommends that the SEC "move quickly to close identified gaps in the current rule." Given the widespread advocacy for modification of Rule 10b5-1, is it practically a fait accompli?
In remarks in June, SEC Chair Gary Gensler indicated that 10b5-1 plans "have led to real cracks in our insider trading regime," and, as a result, he indicated that he had asked the staff to make recommendations for a proposal to "freshen up" Rule 10b5-1. Some of the new limitations Gensler suggested should be considered in a proposal are comparable to some of those included in the IAC subcommittee draft recommendations, include mandatory "cooling-off" periods, mandatory disclosure regarding the adoption and modification of Rule 10b5 1 plans, and limits on the number of 10b5-1 plans an individual can adopt. With regard to cooling-off periods, Gensler cited research showing that 14% of sales in 10b5-1 plans are initiated within 30 days of plan adoption, and about 40% within the first two months. Former Chair Jay Clayton and Commissioners Allison Lee and Caroline Crenshaw have all advocated four- to six-month cooling-off periods, and Gensler said that he believed that "this approach deserves further consideration." (See this PubCo post.)
Background. Corporate executives, directors and other insiders are constantly exposed to material non-public information, making it sometimes difficult for them to sell company shares without the risk of insider trading, or at least claims of insider trading. To address this issue, Congress developed the Rule 10b5-1 safe harbor. In general, Rule 10b5-1 allows an insider, when acting in good faith and not in possession of MNPI, to establish a formal trading contract, instruction or plan that specifies pre-established dates or formulas or other mechanisms-that are not subject to the insider's further influence-for determining when the insider can sell shares, without the risk of insider trading. To be effective, the contract, instruction or plan must also conform to the specific requirements set forth in the Rule. In effect, the Rule provides an affirmative defense designed to demonstrate that a purchase or sale was not made "on the basis of" MNPI. If a 10b5-1 contract, instruction or plan is properly established, the issue is not whether the insider had MNPI at the time of the purchase or sale of the security; rather, that analysis is performed at the time the instruction, contract or plan is established.
After the plan has been established, there is no requirement for a cooling-off period-that, is the plan can provide for immediate trades. In addition, the insider can modify it, so long as he or she is not aware of MNPI at the time of the modification, and can terminate it at any time-even if the insider is in possession of MNPI at the time. Why is that? Because the termination (and related cancellation of any planned trades) is not "in connection with the purchase or sale of any security." Plans can be used for a single trade, and there is no requirement that multiple trades be spaced apart. An insider can also adopt multiple plans that operate at the same time. Although there are requirements that insiders report transactions on Forms 4 and 144, there is no independent public reporting requirement for 10b5-1 plans (other than the requirement on Form 144 to provide the date of plan adoption if the sale was under a 10b5-1 plan). However, some insiders do provide that information voluntarily. Some view the ability to adopt multiple plans, to trade immediately upon adoption and to amend or cancel the plans as providing opportunities to exploit the Rule. As a result, the IAC subcommittee suggests, many observers have raised concerns "that Rule 10b5-1 may help shield opportunistic insider trading from legal, regulatory and market scrutiny, questioning whether the rule needs to be strengthened."
Draft recommendations. The IAC subcommittee draft recommendations fall into two categories: recommendations for affirmative defense protection and recommendations for plan reporting and disclosure.
The subcommittee offered two recommendations regarding affirmative defense protection:
- "Require a 'cooling off' period of at least four months between the adoption or modification of a Rule 10b5-1 plan and the execution of the first trade under the newly adopted or newly modified plan.
- "Do not allow overlapping plans (i.e., a single person or entity may not have more than one Rule 10b5-1 plan at a time)."
The subcommittee cites several studies conducted on the use of Rule 10b5-1 plans that raise concerns that "some plans are used to engage in opportunistic trading behavior that contravenes the intent behind the rule. In particular, the timing of plan adoptions, modifications, and cancellations, appear to present a heightened risk of potential misuse." For example, a 2006 study showed that "sales under trading plans were followed by stock underperformance of nearly 3% relative to the market over the ensuing six months." The study pointed to the "free cancellation option" (regardless of whether the insider is in possession of MNPI) and the potential for trading during blackout periods, both of which could permit opportunistic trading behavior. The study also found "statistically significant forward-looking abnormal returns" from 10b5-1 plan trades. The IAC subcommittee also highlighted more recent research that identified three "red flags" of Rule 10b5-1 plans "associated with opportunistic trading behavior, with a focus on mitigating opportunistic loss avoidance." The subcommittee suggests that extending the cooling-off period could mitigate these problems, noting in particular that a cooling-off period of "at least four months would ensure that insiders could not adopt a plan that executes a trade in the same quarter--the trade would necessarily be in the following quarter. Further, limiting the 'affirmative defense' protections under Rule 10b5-1 to a single active plan would signal to the market that a plan was entered into in good faith."
In this paper, Gaming the System: Three 'Red Flags' of Potential 10b5-1 Abuse, cited in the recommendations, the authors, from the Rock Center for Corporate Governance at Stanford, examined data from over 20,000 Rule 10b5-1 plans to investigate the extent of insider trading abuse. The study found that some executives did use 10b5-1 plans to conduct "opportunistic, large-scale selling that appears to undermine the purpose of Rule 10b5-1." Although the authors acknowledged that they could not determine for certain whether any insiders that avoided losses or otherwise achieved "market-beating returns" actually traded on the basis of MNPI, they contended that average trading returns of the magnitude they found in the study "are highly suspect and, as such, these red flags are suggestive of potential abuse." The authors identified three "red flags" that could be used to detect potentially improper exploitation of Rule 10b5-1:
"1. Plans with a short cooling-off period
2. Plans that entail only a single trade
3. Plans adopted in a given quarter that begin trading before that quarter's earnings announcement."
The study showed that there is substantial variety in the duration of cooling-off periods, including 1% of plans that had no cooling-off period at all and began trading on the same day as plan adoption. About 14% of plans began trading within the first 30 days and 39% within the first 60 days. Only 29% of cooling-off periods were four months or longer. The study also showed a correlation between initial trade size and duration of the cooling-off period, with trades under plans with cooling-off periods of less than 30 days being about 50% larger (median $573,000) than trades under plans with a cooling-off period of six months or more (median $360,000). However, the largest median initial trades (at $619,000) occurred with cooling-off periods of 61 to 90 days and, at 91 to 120 days, the median was $615,000.
Perhaps most interesting, the authors also looked at "loss avoidance," calculated against industry-adjusted stock returns over the six months after the first planned sale, i.e., the greater the negative return following the sale, the greater the loss avoidance. The study found "that trades of plans with short cooling-off periods avoid significant losses and foreshadow considerable stock price declines that are well in excess of industry peers." In addition, the "shorter the interval between plan adoption and the first trade, the more likely it appears that the plan is being used opportunistically. With longer cooling-off periods, opportunistic trading disappears."
In the study, 49% of plans covered only a single trade. Notably, the data showed that trades under single-trade plans were "consistently loss-avoiding regardless of cooling-off period. Single-trade plans with short cooling-off periods exhibited the highest average loss avoidance. (See this PubCo post.)
The IAC subcommittee offered four recommendations regarding plan reporting and disclosure:
- "Require electronic submission of Form 144.
- "Require enhanced public disclosure of Rule 10b5-1 plans,
- a. Proxy statement disclosure of the number of shares covered (i.e., scheduled for sale) under Rule 10b5-1 trading plans by each of the Named Executive Officers.
- b. Proxy statement disclosure of the total number of shares covered (i.e., scheduled for sale) under 'corporate' Rule 10b5-1 trading plans (i.e., Rule 10b5-1 plans established by the issuer itself for the purpose of selling treasury shares).
- c. Disclosure on Form 8-K of the adoption, modification, or cancellation of Rule 10b5-1 plans, and the number of shares covered, on a timely basis (i.e., change 8-K rules to include changes to plans by affiliates as material non-public information requiring an 8-K).
- "Enhance disclosure of 10b5-1 trades, including the
modification of Form 4 to include the following new, required
- a. Checkbox to indicate whether a specific trade was pursuant to a Rule 10b5-1 plan.
- b. A new field to indicate the date of associated Rule 10b5-1 plan adoption or modification.
- "Ensure all companies with any securities listed on U.S. exchanges (including ADRs and ADSs filing Form 20-Fs) are subject to Form 4 reporting requirements."
The recommendations contend that the lack of transparency around plan adoptions, modifications, terminations and trades "creates a black box around plans that effectively shields insiders from investor scrutiny and possible enforcement action in cases of potential abuse." Much of this information is not only unavailable to the public, it is also unavailable to the SEC. Better disclosure, the subcommittee suggests, would help to assure the public that trades under Rule 10b5-1 plans "are conducted in good faith and not used by insiders to circumvent insider trading rules."
The IAC subcommittee noted, for example, that there is no requirement that Forms 4 report whether the transaction was made under a Rule 10b5-1 plan or the date of adoption of a Rule 10b5-1 plan. In addition, insiders of non-U.S. companies are not even required to file Forms 4 and, as a result, are "shielded from disclosing any trades." Although Form 144 does require disclosure of the adoption date of a Rule 10b5-1 plan that is applicable to the planned sale, Form 144 is not required to be filed electronically; almost all are filed on paper and many handwritten, making access and analysis difficult. According to the IAC subcommittee, "these disclosure gaps: (1) prevent proactive risk assessment and policing by the market; (2) limit the Commission's ability to actively and efficiently monitor the adoption, modification, or cancellation of plan details, for enforcement purposes; and (3) reduce market efficiency by obscuring potentially material signals (such as a sizeable sale by an executive) from full view." These problems could be easily remedied, the recommendations suggest.
In addition, to the extent that there is other information that the SEC believes to be "necessary to effectively monitor trading plans established under Rule 10b5-1," the IAC subcommittee recommends that the SEC "pursue regulatory action to obtain that information if not unduly burdensome to issuers and insiders."
In June, in a bipartisan move, Senators Chris Van Hollen and Deb Fischer reintroduced S. 2211, the "Promoting Transparent Standards for Corporate Insiders Act." According to the press release, the legislation is designed to address concerns that some insiders "may be abusing loopholes in this system, which hurts everyday investors and reduces confidence in the integrity of our capital markets." The bill would require the SEC to conduct a study to determine whether Rule 10b5-1 should be amended, report back to Congress within 180 days and amend Rule 10b5-1 within a year consistent with the study's findings. Under the bill, the SEC would be required to look at, among other things, whether Rule 10b5-1 should be amended to require issuers and insiders to adopt 10b5-1 plans only in open trading windows; limit the ability of issuers and insiders to adopt multiple 10b5-1plans; establish a cooling-off period; limit the frequency with which issuers and insiders may modify or cancel 10b5-1 plans; and require filing with the SEC of 10b5-1 plans upon adoption, amendment, termination and transaction under a 10b5-1 plan. A similar bill has already passed in the House. (See this PubCo post.)
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