SEC Action Against Cheetah Mobile Execs Shows Rule 10b5-1 Plans Are Not a Get Out of Jail Free Card

On September 21, 2022, the Securities & Exchange Commission announced a settled enforcement action against two executives of China-based mobile internet company Cheetah Mobile, Inc. The SEC alleged that Sheng Fu, Cheetah Mobile’s CEO, had caused the company’s misleading statements and failures to disclose a material negative revenue trend and that, after becoming aware of the trend, he and Ming Xu, Cheetah Mobile’s former President and Chief Technology Officer, sold securities pursuant to an improperly established Rule 10b5-1 trading plan and avoided a few hundred thousand dollars in losses. This is a rare SEC action stemming from improper use of a Rule 10b5-1 trading plan, and it may signal a shift in future SEC enforcement and increased scrutiny of trading pursuant to Rule 10b5-1 trading plans.

Key Takeaways

• The SEC is closely scrutinizing Rule 10b5-1 plans, and such plans should not be seen as get out of jail free cards to avoid insider trading liability;
• Insiders cannot be in possession of material nonpublic information (MNPI) when they put a plan in place; otherwise, the plan cannot serve as an affirmative defense to an allegation of insider trading;
• The SEC’s view of information that constitutes MNPI may be expanding and what is considered material will be assessed with hindsight; and
• The best practice for Rule 10b5-1 plans is to have a cooling-off period between putting the plan in place and when the planned trades begin.

Facts of the Case

Cheetah Mobile earned up to one-third of its revenues from an advertising partner that placed third-party advertisements on Cheetah Mobile’s mobile platforms. In the summer of 2015, the advertising partner informed Cheetah Mobile that it would be changing its algorithm that determined the fees for ad placement and that, unless Cheetah Mobile improved the quality of its ad placements, the algorithm change could cut the partner’s payments to Cheetah Mobile in half. Cheetah Mobile was unable to accommodate the new algorithm but, according to the SEC, when its revenue began to decline, Cheetah Mobile’s CEO offered a materially misleading explanation to investors and analysts during an earnings call when he referred to the decline in revenue as being due to “seasonality” and caused by “some declines in one of our largest third party advertising platform partners, where we see significant sequential moderations in sales there.” The SEC alleged that the CEO’s statements about revenue trends and expectations were materially misleading because the CEO did not disclose that the algorithm change had a created a negative trend in revenue and the trend was persistent and not seasonal. The company also failed to disclose this “known trend” in its annual report filed with the SEC that the CEO signed.

The SEC alleged that while they were aware of the material negative trend in revenues from the advertising partner, Cheetah’s CEO and then-President entered into Rule 10b5-1 trading plans to sell some of their Cheetah Mobile securities. The SEC claimed that because they sold before Cheetah Mobile disclosed lower than expected second-quarter guidance, the executives avoided losses of approximately $203,290 and $100,127, respectively. 

A New Enforcement Trend?

This case is unusual for at least a couple reasons. First, the SEC seldom charges individuals who have traded pursuant to Rule 10b5-1 trading plans. Rule 10b5-1 trading plans can be particularly useful for individuals presumed to have nonpublic information, such as directors, officers, or executives of a company. By certifying that they do not possess material nonpublic information at the time they enacted the plan, they can establish an affirmative defense to a charge of insider trading, even if they become aware of MNPI after the plan is in place but before the trade is completed. But the existence of a Rule 10b5-1 trading plan, standing alone, is not enough to protect against liability: the plan must be entered into in good faith. While insider trading actions involving Rule 10b5-1 plans are not common, the SEC has shown that trades made while executives had knowledge of nonpublic information will be scrutinized, even if a Rule 10b5-1 plan exists.

Second, the SEC’s definition of what information constitutes MNPI may be expanding. While many insider trading cases relate to earnings announcements or potential mergers and acquisitions, in this case the MNPI that the executives were charged with trading on was an undisclosed negative revenue trend. Interestingly, when the executives entered into the Rule 10b5-1 trading plans, Cheetah Mobile had already disclosed that it expected a decline in overall revenues in Q1 2016 compared to the immediately preceding quarter. But the company had not disclosed that the change in its advertising partner’s algorithm had created what the SEC alleged was a negative trend in revenue. 

Best Practices

On December 15, 2021, the SEC proposed amendments to the rules for Rule 10b5-1 trading plans. While these rules have not yet been enacted, the Cheetah Mobile case signals an increasing appetite for heightened scrutiny of Rule 10b5-1 plans and subsequent trades. For years, critics have noted that executives and insiders who trade pursuant to Rule 10b5-1 plans are more successful than others who do not use these plans and that the timing of trading and establishment of the plans seem to “game the system.” The SEC’s proposed rules—along with the Cheetah Mobile enforcement action—may also identify best practices for those who wish to trade pursuant to Rule 10b5-1 plans without exposing themselves or their companies to risk.

No MNPI When Establishing a Rule 10b5-1 Plan: Individuals who wish to trade should make sure that they are not in possession of material nonpublic information when they establish the Rule 10b5-1 plan. Companies and individuals wishing to trade should also think carefully about what might be considered material to investors; for example, an undisclosed negative trend in revenue could be material. 

Institute a Cooling-off Period: Insiders should also consider a “cooling-off” period between enacting the plan and when trades begin under the plan. The SEC has proposed a period of at least 120 days; although no such restriction is currently in place, a delay between adoption of the plan and the start of trading can help support an argument that the plan was established in good faith. Notably, as part of the settlement, Cheetah Mobile’s CEO agreed to a 120-day cooling-off period for any new Rule 10b5-1 plans he establishes for the next five years. 

Ensure Robust Internal Controls: Companies and their counsel should also ensure that they have robust internal controls. They should look closely at their insider trading policy, enforcement of trading windows for enactment of Rule 10b5-1 plans, and review of modifications to Rule 10b5-1 plans. Because the SEC has proposed heightened disclosure requirements for Rule 10b5-1 planned trades, companies may also want to consider disclosure of executive plans.

By planning carefully, enacting strong internal controls, and thinking critically about what might be considered MNPI, companies, insiders, and their counsel can reduce risk and stay ahead of a shifting compliance landscape.

Learn more about Rule 10b5-1 plans and best practices, or listen to the MoFo Perspectives podcast “Above Board: Rule 10b5-1 Plans.” For more information about enforcement trends and proposed changes, please refer to our alert “Rule 10b5-1 Plans at 20.”