The Rise of Rule 10b5-1 Enforcement and How Companies Can Mitigate Risk of DOJ and SEC Actions

The U.S. Department of Justice (DOJ) and Securities and Exchange Commission (SEC) have recently intensified their scrutiny of insider trading under Rule 10b5-1 trading plans. The emerging trend of enforcement investigations and actions in this area shows that regulators and prosecutors are keen to hold executives accountable for insider trading. Companies and executives should adopt best practices to mitigate the risk that trading pursuant to a Rule 10b5-1 plan could result in an insider trading investigation.

Key Takeaways:

• The SEC and DOJ are increasingly using data analytics to identify and initiate investigations of suspicious trading under Rule 10b5-1 plans, which are intended to shield companies and executives from insider trading allegations by letting them schedule transactions in advance;
• Rule 10b5-1 plans, standing alone, cannot insulate corporate executives and employees from insider trading liability;
• Insiders cannot possess material nonpublic information (MNPI) when they put a Rule 10b5-1 plan in place; otherwise, the plan will not serve as an affirmative defense to an allegation of insider trading;
• The SEC has proposed amendments to the rules for Rule 10b5-1 plans, including a “cooling-off” period of at least 120 days between enacting the plan and when trading pursuant to the plan can begin;
• The SEC’s view of information that constitutes MNPI may be expanding, and what is considered material will be assessed with hindsight; and
• Companies should consider adopting the following for Rule 10b5-1 plans:
• Institute a Cooling-off Period: Companies and executives should consider a “cooling-off” period between enacting the plan and when trades begin under the plan. Although no such restriction is currently in place, the SEC has proposed a period of at least 120 days, which would span an entire quarter, meaning that no trading could occur under a Rule 10b5-1 plan adopted in a particular quarter until after that quarter’s financial results are released. Adopting a cooling-off period designed to delay trading under a Rule 10b5-1 plan until after quarterly earnings are publicly announced can support an argument that the plan was created in good faith.
• Ensure Robust Internal Controls: Companies should ensure that they have robust internal controls that are consistent with SEC rules and enforcement developments. They should look closely at their insider trading policy, enforcement of trading windows for enactment of Rule 10b5-1 plans, and review 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 prepare for possible disclosure of executive plans.
• No Overlapping Plans: The SEC’s proposed rules prohibit “overlapping” Rule 10b5-1 trading plans. The SEC explained that, under the current rules, an insider can exploit Rule 10b5-1 plans by using them to establish multiple pre-existing hedged trading arrangements that temporally overlap and are timed to occur around dates on which the issuer is likely to disclose earnings or other material information. An insider may decide later which trades to execute and which to cancel under the plans after the insider  becomes aware of MNPI but before the MNPI is made public. Under the proposed amendment, the affirmative defense would not be available for any trades by a trader who has established multiple overlapping trading arrangements for open market purchases or sales of the same class of securities. Companies should understand how directors and officers are using these plans and consider adopting a policy of prohibiting multiple overlapping plans.

What are Rule 10b5-1 Plans?

Rule 10b5-1 plans are intended to provide companies and corporate insiders an affirmative defense to insider trading. Under such plans, insiders are permitted to buy or sell a predetermined number of shares at a predetermined time, but only while they do not possess MNPI. In theory, an executive is insulated from liability when the Rule 10b5-1 plan is enacted before the executive possesses MNPI and trading pursuant to the plan occurs after the executive obtains MNPI. 

Since the SEC created rules for Rule 10b5-1 plans over two decades ago, companies have widely adopted such plans. On December 15, 2021, the SEC released proposed amendments and disclosure requirements pertaining to Rule 10b5-1 plans. The proposed amendments would update the requirements for the affirmative defense, including imposing a cooling-off period before trading can commence under a plan, prohibiting overlapping trading plans, and limiting single-trade plans to one trading plan per 12-month period.

A New Enforcement Trend?

The SEC and DOJ are using data analytics to investigate unusual trading activity and potential abuses of Rule 10b5-1 plans. According to one news report, federal authorities are preparing to bring multiple cases. In October, one company disclosed that it had received subpoenas from both the DOJ and SEC seeking materials concerning the trading activities of a former Chief Executive Officer in 2019 and 2020.

In September, the SEC announced a settled enforcement action against two executives of China‑based mobile internet company Cheetah Mobile, Inc. The SEC alleged that Cheetah’s CEO had caused the company’s misleading statements and failure to disclose a material negative revenue trend and that, after becoming aware of the trend, he and Cheetah’s former President and Chief Technology Officer sold securities pursuant to an improperly established Rule 10b5-1 trading plan and avoided hundreds of thousands of dollars in losses.

Our recent client alert on the Cheetah enforcement action offers two lessons. First, the SEC has shown that trades made while executives had knowledge of nonpublic information will be scrutinized, even if the trades were placed pursuant to a Rule 10b5-1 plan. Second, the SEC’s definition of what information constitutes MNPI may be expanding and evolving. While many insider trading cases relate to earnings announcements or potential mergers and acquisitions, in this case, the MNPI that the executives allegedly traded on was an undisclosed negative revenue trend.

The reports of the DOJ and SEC investigations using data analytics reveal proactive enforcement and increased scrutiny of trading pursuant to Rule 10b5-1 trading plans. The use of data analytics on Rule 10b5-1 plans to initiate investigations evokes a similar pattern of parallel civil and criminal actions brought by the DOJ and CFTC to prosecute “spoofing”—illegal trading practices used to manipulate the commodities market.

Conclusion

Federal investigations of insider trading under Rule 10b5-1 plans have recently intensified and will likely continue. Companies and executives should consider adopting best practices to avoid exposing themselves to risk. A Rule 10b5-1 trading plan, standing alone, cannot insulate an executive from liability for insider trading, and using a plan in ways regulators deem “abusive” may invite scrutiny.